U.S. Review
A More Moderate Contraction
Signs continue to emerge which suggest the rate of decline in economic activity is moderating. Real GDP will still likely post a decline in the second and third quarters but the drops should be considerably less than what we saw in the past two quarters. Job losses should also moderate, although the recent spate of vehicle-assembly plant shutdowns and dealer closings may cause layoffs to spike again this summer.
Recent economic reports support the notion that the contraction is moderating. The Leading Economic Index rose 1.0 percent in April, marking its first increase in seven months and most significant gain since June of last year. Seven of the ten indicators increased during the month, with the most significant gains coming from stock prices, the interest-rate spread and consumer expectations.
The large improvement in the financial components of the LEI takes some of the shine off April’s increase. Still, the large aggregate increase is hard to dismiss and confirms other anecdotal reports that suggest conditions are either bottoming out or close to it.
More Moderate Declines Today Point to Growth Later This Year
Critics of the LEI often point to the misleading signal the index sometimes gives. While this is true, applying some simple common sense helps to understand this report. Rising stock prices accounted for 0.4 percentage points of April’s increase in the LEI. The increase reflects a 12 percent rise in the S&P 500 that month. The stock market has reversed a surprisingly large part of its losses from last fall. Those losses have been a persistent burden on economic activity, adding to the drag on household wealth from falling home prices and depressing consumer spending. Even the partial reversal we have seen since early March should have some positive impact on consumer behavior, particularly since unanticipated changes in household wealth tend to have a larger impact on consumer behavior than anticipated ones.
While the leading index increased, there is little doubt the recession is still on. The Coincident Index fell 0.2 percent in April, reflecting continued declines in nonfarm employment and industrial production. Income and business sales are both expected to post modest increases for the month.
Another way to determine how much weight to give the stronger LEI increase is to ask whether it is consistent with other economic reports. We believe it is, although most reports continue to point more to a lesser rate of deterioration than to an outright turnaround in economic activity. This is the normal progression the economy moves through as it emerges from a recession.
The Philadelphia Fed’s survey of manufacturing conditions rose 1.8 points to -22.6 in May, returning the index to its highest level since September. A reading of -22.6 is still very negative and points to continued contraction in the factory sector. The pace of decline is lessening, however. More importantly, the improvement in the index was broad based, consistent across nearly every component and makes intuitive sense. The employment component rose 18.1 points, which was the sixth largest monthly increase on record. The average workweek also increased, climbing 18.0 points. Both series remain in negative territory, at –26.8 and –23.2, respectively.
There is no doubt employment conditions will remain negative for some time, but here too there are reasons to hope that future declines will be less negative. Weekly first-time unemployment claims declined by 12,000 and the four-week moving average of jobless claims declined for the fifth time in the past six weeks. The claims are still consistent with large job losses and rising unemployment, but the rate of deterioration in employment conditions should soon begin to moderate.
Global Review
Greenback Takes It on the Chin
The dollar got smacked this week. For example, the euro rose to its highest level vis-à-vis the greenback since the beginning of the year (see graph at the left). The euro did receive a bit of a boost from some stronger-than-expected data. As shown in the top graph on page 4, both the manufacturing and service sector PMIs posted sizeable gains in May. Although the indices remain below the demarcation line that separates expansion from contraction, the data suggest that the Euro-zone economy is getting closer to the bottom.
However, there is more to the dollar’s broad-based weakness recently than simply better-than-expected data in the Euro-zone. Not only did the greenback fall about 3 percent against the euro this week, but it also slipped 1 percent against the yen and about 4 percent versus sterling and the Canadian dollar. What is going on?
Debt Concerns Contribute to Dollar Weakness
For starters, the dollar has been highly correlated with risk aversion over the past few months. That is, as risk aversion rises the dollar tends to strengthen and vice versa. With investors becoming less risk averse, the greenback has lost some of its safe-haven appeal. The S&P 500 has risen more than 30 percent from its lows in early March, and a widely followed index of emerging market stocks is up nearly 40 percent over that period (see middle chart).
In addition, the dollar was hit this week by concerns about the ballooning deficit and debt of the U.S. federal government. Although there really were no new developments on the U.S. fiscal front this week, the dollar was hit, ironically, by news that the United Kingdom could eventually lose its AAA bond rating from Standard and Poor’s. How does news about Britain’s bond rating have a negative effect on the dollar? The answer is that the United States could also lose its AAA rating someday as well. If a downgrade were to occur, the safe-haven appeal of the dollar would suffer even more. The yield on the 10-year Treasury security shot up 17 bps on the day the news broke (see bottom chart).
Any downgrade to the United States’ bond rating is not imminent. Some analysts speculated that any downgrade, should one even occur, probably would not happen for 3 or 4 years. In response to the concerns over the government’s fiscal position, Treasury Secretary Geithner said that the Obama administration is committed to bringing the budget deficit down “to a sustainable level over the medium term.”
Concerns over the U.S. fiscal outlook are not likely to disappear just because the Treasury Secretary uttered a few reassuring words. Therefore, the dollar could remain under downward pressure, at least in the near term. However, the scrutiny on the U.S. fiscal outlook will probably fade over time, and investors will likely start to re-focus on growth prospects. As we outlined in “The Global Economy: Who Gets Out of the Gate First?” (available on our website), we project that the United States will be one of the first major economies to emerge from the current slump. As growth prospects begin to improve, the dollar should trend higher again. That said, the greenback could suffer some further losses in the near term if investors continue to fret over the U.S. fiscal outlook.
