Friday, December 10, 2010

Point of View: Interest Rate Watch - Credit Market Insights - Economic Outlook

Interest Rate Watch
Clear Sailing For Higher Rates?

The apparent agreement between the Obama Administration and Republicans on extending the Bush-era tax cuts and reducing social security taxes by two percentage points has caused forecasters to raise their forecasts for 2011 and to become even more bearish about the intermediate to long-term outlook for the federal budget deficit and Treasury issuance.  Long-term bond yields soared this week before rallying back following Thursday’s betterthan-expected auction of 30-year bonds.

We believe the bond market has again gotten ahead of itself.  There is no question the economy is improving and, even with the unexpected blow back by the Democrat leadership, the apparent agreement on extending the tax cuts is still likely to pass. The assumptions being made on the impact of the agreement may be a bit of a stretch.

Expectations for economic growth have been ramped up to 4 percent plus by many forecasters and talk  about the budgetary impact tops out at around $1 trillion. We think the market is paying too much attention to these outsized estimates. If growth turns out to be that much stronger, the budget deficit, and Treasury financing needs, would almost certainly be less.

Our own forecast calls for a much more modest boost. Extending the lower rates on dividends and capital gains and continuing to pay extended unemployment does not provide any incremental stimulus to the economy.  The boost to 2011 comes primarily from the reduction in the social security payroll tax from 6.2 percent to 4.2 percent, which will put more money into consumers’ pockets. Overall growth, however, will only likely be a few tenths percentage points higher than otherwise.

The tax compromise has also led to questions as to whether the Fed will need to  continue  it  QE2  program.  It  will. Inventory rebuilding and federal government stimulus are still diminishing. While a double-dip recession looks much less likely today, a return to 4 percent plus GDP growth would likely require more improvement in the housing sector than we are likely to see over the next few quarters.

Credit Market Insight
Consumer Credit Expands

Overall consumer credit outstanding expanded by $3.4 billion in October on a seasonally adjusted basis. Revolving credit, such as credit cards, fell by $5.6 billion. Built-up savings, high unemployment,account closures and hefty charge-offs continue to drag down revolving credit.

Meanwhile, non-revolving credit jumped $9.0 billion. Although annualized auto sales hit a two-year high 12.25 million units in October, there is more than meets the eye regarding the increase in nonrevolving credit. Breakdowns by institution type are only reported on a non-seasonally-adjusted basis. Digging into the details, we see that finance company nonrevolving credit, which is primarily auto loans, declined by $26.0 billion. That would seem to indicate that consumers are financing autos via bank loans rather than auto dealer loans.
However, we can also see that nonrevolving credit at commercial banks, a good portion of which are auto loans, also declined. That would suggest little in the way of auto financing from commercial banks as well.

Thus, either charge-offs are overwhelming new auto loans at both finance companies and commercial banks or consumers are making cash purchases. In any event, it does not appear that auto loans are driving the increase in nonrevolving credit. Rather, the big increase came from federal government loans, primarily student loans, which rose $31.8 billion. Thus, sans education, consumer credit is generally still contracting.

Economic Outlook: Turning the Corner in 2011
This week, we released our report:  Annual Economic Outlook 2011. In our outlook this year, we have chosen to examine the path dependence issue that defines our expectations for the economy and the options for private and public decision-makers in their strategic planning for the year ahead. The economic recovery in 2011 begins with four main challenges. First, unconventional monetary policy tools have been employed on a massive scale in an attempt to prevent a deflationary spiral, a process responsible for deep recessions in the United States in the 1930s and Japan in the 1990s. Second, we are limited by the policy decisions of the past 40 years, which have levered our government, both federal and local, to unsustainable levels. Several of our most populous and politically important states, such as California and Florida, are among the worst examples of these troubling trends. Third, both the public and private sector fueled a bubble that blinded households
and investors alike to the true value of assets in the housing market. Today, with continued government
intervention and oversupply, the market still cannot indicate the true values of real estate. Finally, the pace of
globalization continues to present challenges to economic actors due to path dependence.

Despite the challenges that face us, we have put the most arduous portion of our journey behind us. We have
turned the corner, and for the year ahead, we believe sustained growth will reflect the influence of continued
improvements in consumer and business investment as well as the turnaround in residential and commercial
construction. We anticipate a change in the composition of growth with less inventory gains and federal spending and greater support for growth from final private demand. Over the next two years, we expect the U.S. economy to grow by 2.6 percent in 2011 and 3.3 percent in 2012.
Full report: Point of View: Interest Rate Watch - Credit Market Insights - Economic Outlook

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