EconPundit

The January report on durable goods demand and production was far firmer than one might think looking at the headline -1.8% figure for new orders. Excluding the volatile defense and aircraft categories, orders were down only 0.3% for the month, and that came on top of an unusually upward revision to December orders for this core group -- now +1.7% month/month rather than just +0.3%. Moreover, even the 0.3% dip overstates the softness of the monthly results, because all of that decline and more came in motor vehicles. Given the sturdiness of car and light truck sales through late 2003 and January 2004, this looks to be an aberration.

Also critically important and impressive were the sharp gains in capital goods orders and shipments. New bookings for nondefense capital equipment other than aircraft jumped 3.6% and were revised up for December by nearly the same amount. This indicates that business firms are gradually ramping up their demands for productive equipment. Meanwhile, shipments of all nondefense capital goods rose 1.8% last month and were boosted 2.5% further for December. This pushed up the Q4 nominal growth rate for capital goods shipments to 11.6% from 7.8%, suggesting that real business equipment spending last quarter will be increased upon revision when the Q4 real GDP figures are revised tomorrow morning.

At bottom, these figures are consistent with other signs (e.g., the ISM surveys) that the manufacturing sector of the economy is moving up smartly.

Apparently there was a recent Merrill Lynch survey of bond price expectations among clients that showed only 4% expect Treasury bond prices to be higher (yields lower) in a year than they are today, and 88% thought prices would be lower (yields higher). In any market, it's extremely rare to find sentiment skewed 22-to-1 in a given direction.

Thus, roughly 4% 10-year Treasury yields today incorporate exceptionally bearish medium-term expectations. While these views may not be expressed through outright shorts, my hunch is they are being expressed by using short Treasury positions to hedge long positions in corporate debt (including junk) and emerging markets debt.

All this suggests there could be a massive pain trade if bond yields were to fall back toward the levels we saw last spring, when 10-year issues briefly visited the 3.25-3.50% zone. Indeed, it probably would not require much of a move down in yields through the recent lows around 3.95% before you'd see some short-covering pressure, and that could precipitate a remarkably fast move down toward 3.75% and below. Look for this to happen by the end of the first quarter.

Another strange and likely unsustainable condition today is that TIPS have been rallying (real interest rates falling) while the nominal 10-year yield has stalled at just over 4%. Thus, the spread between the two has gone out to over 230 basis points, meaning that investors break even or do better buying nominal Treasuries today if the average inflation rate is at or below 2.3% over the next 10 years.

Most likely, the rally in TIPS is a signal that bond yields are under fundamental downward pressure and the nominal market hasn't caught up yet in part due to sticker-shock problems. The actual inflation situation is very benign and indeed still declining. Year/year core CPI inflation held at just 1.1% last month, and shorter-term changes are even slower. Price disinflation in services is apt to persist, considering the erosion of wage gains and stronger efforts to attack benefits cost inflation, plus the substantial decline in unit labor costs over the past year.

Look for the Treasury10-year yield to fall sustainably below 4% very soon, perhaps against the background of a stock-market slide (see earlier comments).

The risk of a sharp decline in the stock market is steadily growing. The technicals of the market's condition look very bad:

1. NASDAQ has fallen below 2000, meaning it has given up all of its gains in 2004 to date.

2. Russell 2000 on Feb. 23 fell below the upward-sloping trendline that has governed its trajectory since last December.

3. The Dow Industrials and Dow Transports are in danger of giving a Dow Theory bear signal, if they both fall below their February 4 close levels (10470.74 and 2822.11, respectively).

More important than this even is that the interactive dynamics of the markets -- currencies, stocks, bonds, and commodities -- could be deadly for stocks. Leveraged players have been betting on a lower dollar and a spur to US corporate earnings from same. If the dollar surges, as we think entirely possible, then hedge funds and large banks with big leveraged positions may sustain big losses and thus have to unwind other big bets such as those on stocks (long, especially small caps and technology) and commodities (long, betting on reflation by the Fed). If the crowding among leveraged accounts in these trades is as great as we suspect, and everyone needs to cut back their risk positions at more or less the same time, it could get very ugly for stocks, the yen and the euro, credit products such as junk bonds and emerging market debt, and inflation-tied commodities such as gold all at once.

The ironic thing would be if a higher dollar triggered a big drop in stock prices, as that's not the way that most people think about these things intuitively. The consensus position is that higher stock prices are good for the dollar, and lower stock prices will hurt the dollar. Thus, funds betting on both higher stocks and a lower dollar probably feel that the two positions are negatively correlated, when in fact they may prove to be positively correlated because of the simultaneous large bets being made across the leveraged community.

The dollar index put in a key reversal today, opening down and trading to new lows before surging upward to close with a significant gain on the day. In fact, the pattern on the chart shows that everyone who sold the dollar over the past five business days is now underwater. The biggest and most sudden change came in the euro/dollar, which climbed a big figure to 1.2925 in early trading and then fell 2-1/2 figures to around 1.2680 at the close.

My comments on the dollar since the beginning of the year have been uniformly suggesting that we are near a big turn, and that market sentiment toward the dollar is more overwhelmingly bearish than I can remember for any instrument in recent years. There is virtually no one in any trading or investing community today who is willing to say the dollar has overshot to the downside, even temporarily. My hunch is we are going to see a lot of shocked people and scrambling to cover short positions in the days ahead, and the move up in dollar/euro and dollar/yen likely will be surprisingly powerful. Today may have been the very first sign that this process is underway.

Figures from the Treasury show a 13% year/year jump in personal income tax refunds last week, so that the cumulative year-to-date change is now +3.0%. This is the long-awaited swelling of refunds to reflect the fact that income tax rates were cut in mid-2003, but people withheld taxes at the higher rate for half the year.

Household spending should get strong support in the first two quarters of this year from the boost to disposable incomes deriving from these extra refunds. In fact, there is some slight evidence this may already be happening. The weekly chain-store sales results showed a 7-1/2% year/year rise for the week ending February 14. That was the strongest weekly year/year result since December 1999.

January budget data (-$1.4bn balance for the month, consistent with CBO estimates) have sustained our belief that the fiscal deficit this year will be much closer to $400 billion than to the $500bn+ estimates thrown around by the White House and others. Based on my tracking model, right now through one-third if FY2004 I'd put the budget on a path to wind up just over $400 billion in the red.

So why would the Administration early this month promote a $521-billion budget deficit outlook, if the truth lies much lower? Answer: politics, after all it is a presidential year. Remember, the final FY2004 budget outcome will be reported only a few weeks before voters go to the polls. If the balance is $100 billion or more better than had been expected, the Bush team can trumpet this fact and it will be front-page news on every major paper, whether their editorial slant is pro- or anti-GOP. They will have no choice but to at least report the fact. And President Bush will be able to claim: (a) the deficit is already falling sharply, so his goal of halving it in four years is on track or better, and (b) it's a stronger-than-expected economy that is helping to narrow the gap.

The initial reaction in the foreign exchange market to Chairman Greenspan's monetary policy report has been to (a) drive yields down sharply, and (b) slam the dollar still lower. The first part of this was a reaction to his repetition that the central bank can exercise "patience" with extremely low short-term rates, due to the lack of inflation or inflationary risks and the still sluggish pace of hiring due to exceptional productivity growth. This response seems reasonable to me. In fact, the bond market had previously appeared to be gearing up for another run down below 4% 10-year yields, but was being held up by the presence of a large Treasury refunding operation and fear that Greenspan might say something significantly different (and more hostile) about the monetary policy outlook. Now that those dangers are swiftly passing, we'll likely see fresh local lows in bond yields, and this is reasonable.

It is the response of the forex markets that seems inappropriate. For now, they are focusing on the yield plunge and taking from that a signal that the dollar should weaken because US-foreign interest rate deficiencies will not close soon. However, what should be at least as important is what Greenspan said directly about his views on the exchange rate in his prepared remarks. To this eye, those comments should be dollar supportive, because what he said was that the recent dollar decline has been sufficient to bring about soon some positive movement in the US trade and current-account balances, to the detriment of European export performance in particular:

"A marked increase in foreign exchange derivative trading, especially in dollar-euro, is consistent with significant hedging of exports to th United States and other markets that use currencies tied to the U.S. dollar . . . although hedging may delay the adjustment, it cannot eliminate the consequences of exchange rate change. Accordingly, the currency depreciation that we have experienced of late should eventually help to contain our current account deficit as foreign producers export less to the United States."

Eventually, the markets should awaken to the import of these words. If it doesn't do so today, then look for Greenspan to use the question-and-answer session in his second testimonial appearance (before the Senate) on Thursday to try to make traders see the light.

The first major week of annual personal tax refund season was a disappointment. Through February 6, cumulative refunds in calendar 2004 have been $18.3bn, versus $19.5bn at the same point in 2003. It's very early, to be sure, but this is somewhat surprising given that the mid-2003 tax rate cut and the continuous shift toward e-filing and other measures to speed refunds should be generating stiff upward pressure on the refund total this winter.

A partial explanation for the phenomenon may be that capital gains taxes are up more than expected year/year, and this has held down refunds. I'm skeptical, however, because if that were the case we should have seen larger mid-January final settlements and that didn't happen.

If this refund pattern persists, it may shift consumer spending toward the March/April time period and out of February.

Although financial markets seem for the moment obsessed with the lower-than-consensus headline monthly change in payrolls, the January jobs report was mostly a status-quo reading and at the margin contained a few more elements that suggest slow but steady improvement in the overall labor market. To wit:

1. Longer workweeks: The average nonfarm and factory workweeks both lengthened a great deal, by 0.2 and 0.3 hour, respectively. These are classic leading indicators of firmer hiring.

2. Increased employment/population ratio: At 62.4%, this important measure of labor market health was the highest since April 2003 and has been gradually rising over the past several months after a slow decline in the late 2000-mid-2003 period.

3. Better mix among jobless persons: There are substantially fewer job losers among the unemployed, both over the past one and three months (-237k and -496k, respectively). Meanwhile, there has been a big jump in the percentage of the unemployed who are people re-entering the labor force to look for work (30.2% in Januray, versus 28.2% the prior month). This is consistent with lower jobless claims in showing a slowdown in job cuts, and it indicates word of better labor demand is making the rounds in the public.

The report also underscores the lack of inflationary pressure in wage determination, as average hourly earnings edged up 0.1% over the month and remained at a rock-bottom 2.0% year/year change.

The implications for policy should be that the Fed is doing the right thing by sitting tight indefinitely on the 1% fed funds rate. There is nothing here to suggest this strategy is generating any risk of inflationary consequences.

January cash budget statistics provide fresh evidence that the Fiscal 2004 budget balance outlook isn't nearly as bleak as current headlines would have you think. Tax receipts on a cash basis rose slightly year/year on a same-day basis (+1.5%, using the first 20 business days for 2003 as well as 2004). Withheld individual taxes were up more than 4%, and the drop in nonwithheld taxes was less than 6%. That's not bad, considering that the drop was twice as large last year, and this time we have the depressing influences of a mid-year tax rate cut that should have limited the need for payments in the January final-settlements period.

I continue to think the final budget deficit will come in a lot closer to $400 billion than $500 billion, let alone the $521-billion figure just released by the White House. That said, tax refunds will be robust in the first five months of 2004, again reflecting that mid-year rate cut and the resulting overpayments that took place during January through June. Already, individual refunds during January (a small and not-too-representative sample) were up nearly 18%.

A couple of data points this morning about inflation:

A. The personal consumption price deflator excluding food and energy rose just 0.8% annualized over the second half of 2003. This is down about 3/4% from where it was running at the same point a year earlier.

B. The ISM manufacturing survey for January posted some remarkably strong readings on the inflation components. The price index surged to 75.5% from 66%, reaching its highest position since March 2000. Meanwhile, the vendor performance index leapt to 60.4% from 58.8%, placing it higher than at any point in exactly nine years.

From this perspective, the coincidence of the above two developments points to troubles ahead for corporate profits versus the rosy expectations that lately have been dominant. Retail price inflation is exceptionally low and falling, and that's a big boat that won't turn around quickly. However, manufacturers are finding it more difficult to obtain physical inputs (lengthening lead times as indicated by higher vendor performance), and are seeing more price increases for their raw materials as a result. This means they are going to have to accept thinner margins in the near term, or else weaker sales if they try to push up prices faster than consumers are used to accepting.

Other data show why consumers likely will stay very resistant to higher prices -- their incomes are rising only very slowly. Personal wage and salary income fell 0.3% in December, and edged up only 1.5% (annual rate) in the second half of last year, while the personal saving rate fell to just 1.3% at year-end from over 2% in Q3 on average.