EconPundit

Now the Bush administration has weighed in with what reportedly will be a $521-billion projection for the Fiscal Year 2004 budget deficit, on the heels of the CBO's $477-billion forecast issued last week. These estimates are each somewhat higher than what was published last summer.

In our view, the signs point to far lower deficits than either of these agencies is (at least officially) anticipating. On a cash basis, through January 15 --about 30% through the fiscal year -- the deficit is almost exactly the same size as it was during the same interval of FY03, when the full-year gap came in below $380bn. That means that to hit even the CBO's projection, the deficit for the remaining 70% of the FY would have to swell by nearly 40%. This seems highly improbable considering the sharply increased growth of GDP and resulting surge in corporate profit taxes.

The tracking system which we use to follow the budget deficit is currently pointing at something less than $400bn. That may be a bit optimistic, but with revenues back in positive year/year territory and no fresh war on the horizon, the final outcome seems likely to be much closer to $400bn than $500bn.

In arriving at their 4% advance eatimate for Q4 real GDP growth -- versus our 6% guesstimate -- the Department of Commerce appears to have decided to take a very conservative approach to nearly every component where assumptions had to be plugged in. For example:

1. In residential investment, they used a 10.5% growth rate while the nominal data through November indicate a 36% annualized pace of advance last quarter, and the monthly housing starts have been off the charts.

2. In net exports, they settled on a $4.5bn quarterly improvement in the balance whereas the October/November average implies around $15bn improvement in the goods sector.

3. In nonfarm inventory accumulation, they show a $15.6bn acceleration (to $9.7bn) while the raw manufacturing and trade figures in book-value terms point to more than a $60bn annualized strengthening in the pace of stocking.

While the projection of less than 1% real annualized growth in government spending may turn out to be correct, and this will impose a drag on the overall GDP figures, our hunch is the final Q4 estimate will wind up in the 5%-6% range after more data inputs are received.

Meanwhile, the report contained still more good news on the inflation front, with the GDP chain-weight index up just 1.1% (annual rate) and the gross domestic purchases index up only 0.9%. Disinflation remains the order of the day, and market participants who have bet on an early reinflation remain exposed to losses.

Here are some thoughts on how markets should take this news:

1. Big flattening of the yield curve. The 2-year/10-year note differential as of the close last night was 242 basis points (1.65% to 4.07%). My thinking is this should move swiftly down to 200bp or lower, with the 2-year yield around 2% and the 10-year at 4% or less.

2. Dollar rebound. The Fed is giving a bit more thought to its low-rate exit strategy, whereas the ECB rate may not have yet bottomed. Dollar bearishness has been positively rampant, and there likely are huge anti-dollar leveraged positions that will have to be at least partly unwound.

3. Stocks have seen their highs for awhile. The huge rally that began last March is long in the tooth, and now while the Fed remains friendly, the prospect of a turn for the worse looms larger over the horizon.

The FOMC today issued a statement that deleted the language stating that the Committee felt rates could stay at current levels "for a considerable period." Instead, it says that "the Committee believes that it can be patient in removing its policy accommodation."

This is a BIG change, and amazingly no one was talking about the potential for it to happen, whereas in early December -- before many recent strong economic reports -- that's all anyone could talk about. They knew this modification of wording would get disproportionate attention. The "considerable period" phrase had taken on major importance in the psychology of market participants, therefore the FOMC would not have changed it in the slightest without significant forethought.

Shifting from "considerable period" to "can be patient in removing" also suggests a desire to enhance flexibility to backpedal from 1% a little bit later this year, if economic growth proves consistently very strong. It would take a very large tightening to "remove" accommodation, starting from 1%, but a small tightening would still be consistent with the notion advanced that they are being "patient" with accommodative policy.

There are fresh statistical indications that the current explosive pace of new housing construction is sowing seeds for a big overhang of unsold houses down the road. December new-home sales data showed a 5.1% decline, although the level remains absolutely robust at 1.06 million annualized. Upward revisions to October and November sales levels mitigated some of this decline.

Far more noteworthy was the further 2.2% increase in the number of houses unsold on the market. This brings the annual rate of increase in the inventory to 27% over the past four months. Thus, even at consistently around 1.1 million annual sales -- record levels -- the inventories of builders are exploding upward at recent production rates. And this doesn't even take into account the further sharp rise in the starts rate during the fourth quarter; those homes whave not yet been completed.

A drop in new-home sales therefore would cause the inventory levels to spike up and likely would trigger a sharp cutback in new production rates (starts). This underscores the need for mortgage interest rates to stay low and probably fall somewhat further if this segment of the economy is to avoid a spectacular bust.

The 5-point jump in the Conference Board's consumer confidence index in January (to 96.8) puts the measure at its highest point since July 2002. The cumulative rise in the index over the past four months has been nearly 20 points.

So what's not to like? The weak underbelly in this survey remains the assessment of labor market conditions. The negative differential between those seeing jobs as plentiful vs. hard to get narrowed only slightly, to -19.0% from -19.8% and a recent wide point of -25.2% in September. By contrast, a year ago the differential was -14.4%, while the overall confidence index at that time was fully 18 points below where it stands now. Clearly, respondents are looking at the future with great optimism, but the message here is that they had better see some direct and tangible rewards very soon or they may turn discouraged.

There is a political message here as well, it seems to me. Bush's dad lost re-election when the public was continually disappointed with how the economic recovery translated to increases in their employment, incomes, and standard of living. Solid GDP numbers toward the end of 1992 did little to help him out. Bush the Second had better be careful that he doesn't repeat the mistake of under-appreciating the stress people are feeling.

The news today on housing has been robust across the board. Starts of new dwellings rose another 1.7% in December to an absurd 2.09 million annual units. Building permits that same month increased 3.3%, and are not just shy of 2 million annualized. Applications for purchase mortgages hit a record high (seasonally adjusted) in the latest week, and using a four-week moving average the purchase index is up 22% from a year ago.

All this data points to a further period when residential construction expenditures will be making solid positive contributions to real GDP growth. This is another reason to think that real GDP growth will keep surprising on the upside for not just Q4 2003, but also the first half of 2004.

That said, there are early signs that all this construction may lead to a big overhang of unwanted dwellings unless demand rises further -- perhaps much further -- in the coming months. Official figures show a steep rise already in the volume of unsold single-family homes between July and November, even with new home sales running at record-high rates over the period. Also, vacancy rates in the apartment sector are unusually high, with more people migrating out of rental housing due to favorable mortgage financing conditions.

Now there are signs that the dollar is getting ready to surge up against the yen, on the heels of its strengthening against the euro, noted last week. After trading briefly below 106, the dollar has been climbing steadily in recent days and stands this morning at 107.40 vs. the yen. All the moving averages for this currency value -- 10, 20, 40, and 50 days -- are bunched together in a tight range near the current level.

One reason the dollar has been climbing I believe is that traders and speculators are coming to grips with the immense size of recent Bank of Japan interventions, and are appreciating their willingness to spend almost a limitless amount this year to suppress the yen. Over the weekend, it was reported that the BoJ has already bought more than $55 billion in calendar 2004! That means in just 2-1/2 weeks they have purchased nearly 1/3 of what they bought all of last year. This lends support to their statements that they are prepared to spend many multiples of historical high amounts in their endeavor.

Update: To all of the above, I can add that the Bank of Japan has just eased monetary policy in a surprise move. By deciding not to sterilize all of their recent pro-dollar intervention, apparently they are trying to catalyze an even more powerful recovery in the greenback vs. the yen.

We may be set up for a massive spike up in the dollar/yen value, because if it breaks out to the upside all the speculators may be forced to buy back the dollar from one another. The BoJ will not sell its new dollar holdings until a very large adjustment has occurred. In the past, we've seen similar conditions of lopsided positioning lead to a move of as much as 5-8 yen in the price over just a couple of days.

The US dollar has rallied significantly against the euro over the past week, after initially falling on news of a disappointing nonfarm payrolls rise on January 9. From a low of around 1.2850, the dollar is now flirting with 1.24.

This rally is probably still in its early stages, and should ultimately bring the dollar/euro rate below 1.20 and possibly toward 1.15-1.17 within weeks. Here are some reasons:

1. Trade data show US by November already had gained sharply in competitiveness. US exports of capital equipment surged between Q2 and November, even after adjusting out the lumpy aircraft series. Meanwhile, it's now official that Germany entered a recession in 2003. These developments indicate the US has grabbed a good chunk of market share in global trade within the business equipment sector. Moreover, these gains were made before the euro made its latest run up from around 1.15-1.16 to 1.25-1.28.

2. Overblown inflationist sentiment has been a key force depressing the dollar. Last week the euro had its ninth straight weekly gain, a weird string considering that US economic news has been robust throughout. This currency change apparently was driven by leveraged speculators who have been betting heavily all on one side, that of an early inflation upturn. As this one-sided bet gets unwound -- and the $13/oz plunge in gold yesterday suggests this is occurring -- the euro strength should unwind swiftly, too.

Today the 10-year US Treasury note yield dipped below 4%, in line with what we suspected would happen after the employment data were released. Though it has moved very far, very fast, and thus may pause for a bit, we suspect the bond rally will continue on trend and will go farther than anyone expects. Here are some reasons:

1. Inflation will keep surprising on the downside. Today's PPI report showed another 0.1% dip in the core finished goods index. Excluding the volatile vehicle group, the finished goods PPI has risen just 0.2% over the year, despite a big drop in the dollar and a sharp acceleration in factory activity. Excess capacity remains large, and import penetration from China is strong and broadening across industries, so goods price inflation should stay nonexistent. Meanwhile, the CPI evidence strongly indicates that service price disinflation has gained momentum and this should continue given the sharp slowing in compensation costs as well as increased outsourcing of services labor.

2. The inflation component of yields hasn't fallen much yet. Surprisingly, the bulk of the recent rally in the nominal bond market was matched by a decline in TIPS yields. The current 2.2% differential between nominal and TIPS yields on both 5-year and 10-year securities seems far too wide, given (a) the disinflationary conditions discussed above, and (b) the illiquidity on TIPS that should put upward pressure on their yields relative to actual real rates. It would not be surprising to see this gap narrow to within 2% over the coming weeks.

3. No soft economic data has yet been seen for months. The bond market has held up remarkably well amid a barrage of strong economic numbers going back to late October. Investors have become conditioned to seeing nothing but strong economic data and an upward trend in stock prices, along with a declining dollar, all of which normally would hurt bonds. If any or all of these negatives are lifted in the near term, bonds could spike to the upside.

4. It seems no one wants to be bullish on Treasuries. A recent poll showed the weakest sentiment for Treasuries since late 2000. This is consistent with the way the market trades, which is to gap to the upside and then consolidate those gains with very little backtracking. It seems very few if any people are available to sell bonds into a rally.

The November trade figures indicate that upward momentum in US exports is quite a bit stronger than seemed possible a few months ago. Total exports jumped 2.9% in the month, on top of an upward-revised 2.8% increase in the prior month. In the merchandise category, the increases for November and October totaled nearly 7% over the past two months. To be sure, some of this strength was generated by a $1.4-billion rise for civilian aircraft, where exports tend to be very lumpy and volatile from period to period.

These data are consistent with earlier survey evidence from the ISM that exports have picked up a lot of support. The ISM manufacturing survey for December placed new export orders at 60.4%, their high since September 1989. This built upon earlier gains that had pushed the index up from the low-to-mid 50's starting in October. The parallel ISM survey of nonmanufacturers has displayed similar gains in export orders, albeit on a not-seasonally-adjusted basis of reporting.

It appears that the weakening of the dollar against the euro and yen that predated the past couple of months already was enough to significantly boost US competitiveness in global markets, especially those for capital goods, where exports have been most robust. That suggests that the recent further rise in the euro in particular against the greenback was fundamentally excessive and apt to be at least partly reversed in coming days.

The December payrolls data were significantly weaker than what had been suggested about the status of the labor market by prior sensitive indicators (e.g., unemployment claims, ISM surveys regarding employment). The tiny 1,000 gain in this employment measure last month and the net 50,000 loss after incorporating revisions likely understates the true condition of labor demand. Consider, for example, that the separate survey of households showed a 234,000 increase in employment for private nonagricultural wage and salary employees. This extends the long-running pattern of household employment running far ahead of the payroll numbers. Also, the temporary worker industry added 30,000 people and has been expanding at nearly a 12% annual rate lately, and diffusion measures of job growth across industries continue to look somewhat firmer.

All that said, it does look as though the pickup in employment activity may have stalled lately. This certainly was the message of the latest consumer confidence survey (for December), where the percentage of respondents seeing jobs as plentiful vs. hard to get declined by several points, to -20%. What this employment report in conjunction with the claims series may tell us is that although layoffs have subsided, the psychological and other forces that have capped fresh hiring at established firms still have not been lifted. Only when the latter occurs can we hope and expect to see payroll gains of a sustainable character in the 200,000+ zone per month.

The other big message from today's report was that wage disinflation remains impressive. Average hourly earnings (+0.2% month/month) are now up just 2.0% year/year, and 1.6% annualized in the past six months. Both figures are at the lows and falling. There are numerous signs that firms regard labor as still a relatively expensive resource. That should keep job growth sluggish until and unless wage gains recede further, and that should bode for a continuation of price disinflation.

Perhaps it is this phenomenon that has kept the bond market well supported even as every other market is being driven by inflationist sentiments. It feels as though 10-year Treasury yields shortly will test and probably pierce the 4% barrier on the downside once again.

Across a range of markets, the price action in recent weeks has been dominated by an inflationist line of thinking, promoted most actively by the leveraged fund community. These money managers and speculators are pushing the thesis that the Fed's current rock-bottom rate policy is ultimately bound to spur much higher inflation. Thus, their investment themes are: weak dollar, strong commodities, and stocks significantly outperforming bonds in 2004.

Just one problem -- the bond market isn't cooperating. Bond yields (10-year Treasuries) today are around 4.3%, in exactly the range they occupied in late October. That was before the US economic data went ballistic, and as the dollar was in the early days of its latest descent. If inflationary risks were as high as the leveraged funds say they are, and the Fed were being as reckless as they believe, then presumably foreign private investors would be dumping so many US bonds the central banks couldn't possibly even in concert prevent yields from rising.

My hunch is that the bond market is the canary in the coal mine, and that fundamental forces are not yet toward inflation but rather remain toward isinflation due to massive excess capacity. If that is true, then the real yields on bonds today are much better than investors appreciate. The big surprise of the first half of 2004 could be that bonds -- especially those with high credit ratings -- may substantially outperform stocks. Moreover, a continued downtrend in US inflation speaks favorably for the dollar versus other currencies, so the sell-off in the greenback seems overdone at this point.

Back after an extended holiday, I continue to be greatly surprised at the low-ness of most forecasts for Q4 real GDP growth. This morning it was reported that the current median forecast is at 4.2%, barely higher than it was a month ago.

How can this be? The news on economic activity over the past month, like that reported in the prior month, has been blockbuster strong. For example, how about the ISM manufacturing index rising to 66.2% in December, led by a surge in the new orders component to the highest point since July 1950? This important measure last quarter averaged 62%, the highest in 20 years, and yet the consensus believes real GDP moved ahead merely at the rate that many now believe to be roughly the trend in potential.

Further, consider the construction statistics reported last Monday, January 5. Total nominal outlays in this sector are now said to have risen 19% annualized in Q4 through November, compared to the 13.7% trend previously indicated. In the private residential sector, the gain was lifted to 36% from 26%. Meanwhile, consumption data have been coming in so far above expectations that the increase is apt to be 3% instead of something like 1-1/2%. All this new information, and yet the forecasters' figures for the quarterly number barely budged!

On December 11 I wrote that indications were growth for Q4 would be in the 5.5%-6.5% range, and now I would revise that range up to 6%-8%. The only thing that could act as a major downside surprise is the trade sector, for which we only have one months' worth of information. I'm willing to bet, based on other indicators, that it won't drain away enough of domestic demand to pull growth down toward 4%.