U.S. Review
The TARP Rolls into Detroit
President Bush authorized the Treasury to loan the Big Three domestic automakers $13.4 billion from the Troubled Asset Relief Program to carry them over into the new year. The bridge loan will forestall bankruptcy and allow the companies time to formulate a viable business plan to get a larger loan from either the government or the private sector.
While the President’s move is certainly controversial, the use of the TARP money removes some of the immediate downside risk to the economy and forestalls the day of reckoning for at least a few months. The economy and financial markets may be in a better position to deal with bankruptcy or restructuring by then.
The Treasury’s bridge loan may also bolster buyer confidence somewhat and give motor vehicle sales a slight, and we stress slight, boost early next year. The recent pace of motor vehicle sales has been below replacement demand and we expect sales to remain below an 11 million unit pace through the first half of 2009. The slow pace of sales will lead to huge production cuts in the first part of next year.
Look for Real GDP to Drop at a Six Percent Pace in the 4th Qtr
Our current forecast has real GDP declining at a six percent annual rate during the fourth quarter and we have output falling at a 3.4 percent pace in the first quarter of next year. Two of the biggest swing variables in our outlook are international trade and inventories. The trade data will subtract between one and two percentage points from fourth quarter real GDP growth because imports have risen sharply and exports have fallen. The rise in imports is mostly petroleum and related products, much of which was shut out of the market in September when hurricanes forced many port facilities, refineries and chemical plants to close. Imports will likely fall back in November and December but not enough to prevent a widening in the trade gap.
While the wider trade deficit will cut into our already weak economic forecast for the fourth quarter, part of the damage will be offset by higher inventories. Inventories are expected to decline during the fourth quarter as manufacturers scale back production and retailers slash prices to sell off merchandise and raise cash. The largest declines in inventories are likely to occur in the first quarter, however, as production is cut back much more severely. The abruptness and depth of the current economic weakness caught many producers, wholesalers and retailers by surprise. As a result, many have far too much raw material, work-in-process, and finished product.
One benefit of having too much inventory and excess productive capacity is that prices are falling. The Consumer Price Index fell 1.7 percent in November, following a 1.0 percent drop in October. Excluding food and energy items, the CPI was unchanged in November following a 0.1 percent drop in October. While falling energy prices account for much of the improvement in the inflation figures, prices for several other items, including cars, clothing and assorted other household items are also falling. Moreover, with housing in obvious oversupply, the inflation figures will remain low and may even decline for a short period of time.
Housing starts plunged 18.9 percent in November to a 625,000 unit pace. Single-family starts fell 16.9 percent and multi-family starts declined 23.3 percent. Builders are having a very tough time getting credit and have been forced to cut development below even what the current depressed level of sales would justify. Permits also declined sharply in the month and remain just below starts. We expect housing starts to fall further in coming months and possibly bottom out in the first half of 2009. The bottom, however, is much lower many people expected only a few months ago.
Global Review
Dollar Gets Pummeled
Remember the dollar rally that started in July? It abruptly came to an end this week. At one point, the euro was up 10 percent versus the greenback before it gave up some of its gains at the end of the week. Moreover, the dollar was broadly beat up this week, (see graph at left) losing ground versus most major currencies and vis-à-vis the currencies of many developing countries.
What explains the dollar’s depreciation this week - and will it continue? Let’s start with the first part of that question. The catalyst for the dollar’s move appears to be the decline in long-term U.S. interest rates that was reinforced by the Fed’s policy decision on Tuesday. Not only did the FOMC slash its target for the fed funds rate to a range of 0 bps to 25 bps, but it essentially committed to keep it there “for some time.” This commitment to keep short-term interest rates at exceptionally low levels for the foreseeable future helped to fuel the rally in the Treasury market this week. (See the table of yields on page 7.). Although government bond yields in other countries have declined as well, they have not fallen to the same extent as U.S. Treasury yields. The decline in U.S. yields relative to those abroad has reduced the relative attractiveness of U.S. assets, which contributed to the dollar’s decline this week.
Other than riskless Treasury securities, foreign investors are generally shying away from U.S. assets at present. Indeed, foreign investors were net sellers of non-Treasury securities to the tune of nearly $100 billion in the third quarter (see top graph). If yields on Treasury securities are dropping rapidly and you’re not interested in buying anything else due to concerns about credit risk, what’s left to buy? Although the current account deficit is starting to narrow (see middle chart), fewer purchases of U.S. assets by foreign investors leads to dollar depreciation.
Now for the second question: will the dollar’s decline continue? Currency markets are very volatile now and anything could happen in the near-term. Looking further ahead, however, we believe the dollar will regain its footing and trend higher versus most currencies. For starters, the current account deficit should continue to narrow due to the collapse in the price of oil and the sharp downturn in U.S. domestic demand that will lead to further declines in imports. The shrinking current account will exert fewer headwinds on the greenback.
In addition, interest rate differentials will probably become less unfavorable for the dollar. The Fed is now done cutting rates, but we believe that both the Bank of England the European Central Bank have 100 bps to 150 bps of further rate cuts to go. Within a few months, yields on U.S. Treasury securities won’t look as bad relative to their foreign counterparts. Moreover, yields on non-Treasury securities have risen significantly, not only in absolute terms but relative to yields on U.S. Treasury securities as well (see bottom chart). Once the economy shows signs of leveling out, investors, both domestic and foreign, will likely become very interested in the yields that high quality corporate bonds offer. In our view, increased capital inflows from foreign investors should cause the dollar to eventually resume its upward trend.
