Despite an increase of 4.9% in gross domestic product (GDP) in the third quarter, the negatives confronting the U.S. economy are many. First, the United States is facing a significant economic slowdown based on the continuing recession in the housing market, the tightening of credit and the negative wealth effects of declining home values. Combine those bitter ingredients with record high oil prices, a softening employment situation and the cheapest U.S. dollar ever, and there are real concerns that the U.S. consumer may cut spending, sending the U.S. economy into a period of protracted weakness.
On Halloween, the Federal Open Market Committee cut the Fed funds rate by 25-basis points to 4.5% and the discount window rate by the same amount to 5%, and said “The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth,” in their accompanying statement. In addition, the Fed revised downward its 2008 projections for real GDP growth to 1.8% from 2.5%, which was down from the June projection of 2.5% to 2.75%; a month later, the Bush administration cut its expectation to 2.7% from 3.1%.
“The aggressive posture that the Fed started taking in August basically delayed what was going to be a recession in 2008, until 2009 or 2010,” says Peter Kefalas, head of research at Denali Asset Management. “We are on course for a serious slowdown, if not a recession, in the New Year,” he says, adding that the strategy has been to delay the recession until after the 2008 elections. He notes that the bond market has been anticipating an easier policy for a while and that the current interest rate on the 10-year Treasury note, which is less than 4%, is not realistic and that market rates should begin climbing to the 4.25% to 4.5% range.
“They just don’t believe that the Fed is serious about risks being balanced,” says James O’Sullivan, U.S. economist for UBS Investment Bank. “We will see if that persists, but the markets are fully pricing in a cut in December,” he says, adding that while the economic situation had not deteriorated dramatically relative to expectations in early December, corporate earnings are down and the financial sector is amongst the worst hit. “Spreads are out; you look at LIBOR and CP [commercial paper] spreads over the funds rate, they are up pretty sharply since the October meeting,” he says, discounting the probability that the Fed would add any restrictiveness to the financial system, which would likely cause growth to slow. At this point, O’Sullivan says that Treasuries and Fed funds futures contracts are looking for another 100-basis points of easing and that fixed income markets have rallied sharply. In addition to slower growth, he expects the unemployment rate, which recently rose to 4.7% from 4.5%, will climb to 5.2% by the third quarter of next year.
THE WAIT
“It’s the most anticipated recession in U.S. history,” says M. Cary Leahey, senior economist for Decision Economics Inc. “You already had a big slowdown. Growth over the last year was only 2.25%. If next year it is 1.75%, that is only a slowdown of a half percent, versus a slowdown from the previous year of 1%, so the slowdown has already come.” He says there will be significant rate cuts, taking us to 4% by mid-2008, and then to 3.5% into 2009; and the Fed’s primary motivation is preventing the spillover from the housing recession and the credit crisis. O’Sullivan says that he is not expecting a recession in early 2008, and that the 1% to 1.5% GDP growth that he projects wouldn’t be recessionary in any conventional sense. Even if unemployment rises to 5.2%, which he admits is recession-like, he is not counting on payroll growth turning outright negative, which he says would be required for a recession. “In the 2001 episode, GDP growth was -0.1% year over year at one point; you had a strong positive quarter, a negative quarter, a positive quarter, a negative quarter, but no consecutive negative quarters. But what defined it as a recession was outright contraction in payrolls,” he says, and if the U.S. economy does land in a full-fledged recession, he would expect even more aggressive interest rate cuts. “The Fed doesn’t have to cut rates for the economy’s sake, but it is all tied together,” says Kim Rupert, Action Economics’ managing director of global fixed income analysis. She is slightly more optimistic, stressing that the underpinnings of consumption are the labor market and wage growth, and she too does not expect employment to contract. “The smaller increases in employment can be written off, to some extent, to productivity. And that’s why we don’t think the economy is headed toward recession any time soon and why we don’t think the Fed needs to cut interest rates,” she says. However, the Fed could cut for other reasons; for example, to provide assurance that it is the lender of last resort, and that it is monitoring the credit and growth situations, so that the financial situation doesn’t completely dry up and to minimize systemic risks.
OPEN HOUSE
While new-home sales increased 1.7% in October, the median home price fell 13% from a year ago, the largest decline since 1970, according to the U.S. Commerce Department, and homebuilders cut new projects by more than 19%. And Kefalas notes that in each of the four housing recessions (See “Permits plunge,” below) the number of housing permits dropped below 1 million units before the next advance, which coincided with Fed easing. The current 1261 level leaves us with room to decline.
“The progressive tightening of mortgage lending conditions during 2007 has been the major factor behind the setback in home sales this year,” says David Seiders, chief economist at the National Association of Home Builders (NAHB). “NAHB expects home sales to begin a gradual recovery in the early part of 2008,” but that is predicated on avoiding recession and an improvement in the mortgage finance system. He is calling for at least two more cuts in short-term interest rates to ensure that those conditions are met.
Leahey explains that over the last two years, construction and housing have fallen by 20% to 25% and account for 5% of the economy, and that the rest of the economy is growing at 3%, which is below our historical average (see “The Anchor: housing,” below). His primary concern is that as credit tightens and home values fall, it will adversely affect consumer spending. “That is the event that the Fed wants to get in front of,” Leahey says. “The Fed is taking out some recession risk insurance by cutting rates in advance of a major slowdown in consumer spending,” and because consumer spending accounts for 70% of GDP, that is not an idle concern.
“We will be skating close to a recession,” says Daniel Alan Seiver, San Diego State University professor of economics and finance, especially if we begin to feel poorer because our wealth, in terms of housing, has decreased. “You throw in $97 per barrel oil and a slowly rising unemployment rate, that’s going to put pressure on consumption,” weakening the economy in the fourth quarter and into the first half of 2008. “Unlike the financial markets, which can collapse in a short period of time and clear out any excess, housing markets don’t work like that,” and given how illiquid housing is, and the fact that owners can live in the house, the recovery could stretch
into 2009.
In November, The Conference Board Consumer Confidence Index declined to 87.3 from 95.2 in October. In a press statement, Lynn Franco, director of The Conference Board Consumer Research Center, said the decline reflects consumers’ apprehension about the short-term outlook due to volatility in financial markets, rising gas prices and likely higher home heating bills this winter. In addition, consumers’ inflation expectations have surpassed the spike experienced this spring.
“It has been quite impressive how the authorities have managed to engineer such a rescue,” Kefalas says. “But at some point in time in the not-to-distant future, the housing collapse will sink the economy in a full-fledged recession.” He will be looking to the equity market to gauge the Fed’s success and should the S&P 500 break below 1325 that will be the cue that authorities have failed to delay the recession.
FOR SALE BY OWNER
The slowing of the U.S. economy is now largely a given, and the very weak U.S. dollar is being openly derided by the likes of rap star Jay-Z and supermodel Gisele Bündchen. Now the question is how the rest of the world will react. Already the deep discounting of financial services stocks has resulted in the Abu Dhabi Investment Authority buying a 5% interest in recently distressed Citigroup Inc. for $7.5 billion; and with the substantially weakened U.S. dollar, foreign investors are likely to start buying up U.S. companies and assets.
“Foreign investment in the U.S. ought to be phenomenal now; and it is because we are offering a fire sale with a 20% decline against the euro,” Leahey says. And given that an outright diversification of foreign currency holdings would hurt entities with large dollar holdings, he expects more direct investment, but that capital flows will weaken, as has been reflected in the Treasury International Capital (TIC) data. The more subtle part of the question is what will happen to other major economies, such as Japan, Korea and China as the composition of the U.S. slowdown targets consumers. (see “US against the World”).
“One of the reasons that interest rates have been trending downward is we have had the foreign buying of our Treasury securities,” says Ronald J. Ryan, CEO of Ryan ALM Inc. “It’s hard to believe that this trend can continue forever. Sooner or later they will diversify; it’s not that they would dump U.S. securities, but they could not grow as much. That has to put pressure on interest rates. Who is going to buy our Treasury securities if they continue to grow in terms of the amount we are trying to finance?”
BUYER BEWARE
While there is little dispute the Fed will continue to be accommodating to avoid more spillover from the housing and subprime problems, the reality is that cheap money is what got us here.
“At some point the Fed is going to have to disappoint Wall Street and not cut rates when Wall Street is screaming for another cut, just to show that Wall Street doesn’t get to call the tune,” Seiver says, and a tightening of lending standards is under way, as reported in last month’s senior lending officer survey.
“I am not sure that rates are going to go sharply higher over the next couple of months, as people are going to want to keep their Treasury holdings close to them,” Rupert says. “I am not sure how much more upside the Treasury market has. But I don’t think that any of these underlying fears are going away soon. It’s a waiting game: waiting for the other shoe to drop. And the fear is that it’s Imelda Marcos’ closet.”