Q2: Make it or Break it

As the first quarter wound down, one of the key features for policy makers and investors has been an increase in uncertainty. Much of the uncertainty may be resolved in the period ahead. In many ways, what happens in the second quarter may very well set the tone for the remainder of the year.

The outlook for the US economy should clarify. The risks to the US economy appear to have increased. There are three areas that require greater monitoring for investors. First, the adjustment of inventories appears to be proceeding slower than expected and this may continue to be a drag on GDP. In particular the inventory of durable goods continues to rise and stood in February at the highest level since mid-2001. Arguably more telling than simply the level of inventories is the inventories relative to sales. That ratio now stands at its highest level since mid-2003, after stabilizing in Q4 2006. Despite the adoption of just-in-time inventories, and improved management of supply chains, the recent gyrations of the business cycle seem particularly influenced by the inventory cycle.

Second, while forward looking data, like some of the PMI and regional Fed surveys suggest that business investment should pick-up, it has remained elusive. There are a couple of benign factors that could be playing a role, like the reduction of fleet car purchases and the impact from the introduction of new software by Microsoft. However, the fear is that there are more malevolent forces at work as well. In particular, the concern is that the quarterly streak of double digit earnings growth likely snapped in Q1. A squeeze on margins and a reluctance to make new investments in equipment is a typical late cycle characteristic. At the same time, it is important to recognize that rarely is weak investment sustained when demand (presently domestic and foreign) remains firm.

The third channel that needs to be monitored is the knock-on effect of the sub-prime woes. There is concern that it delays the recovery of residential construction (an important component of GDP), prompts a more aggressive tightening of credit standards, and saps the strength of the consumer. Thus far the actual evidence of the sub-prime problem spreading or becoming more generalized has been very light. This remains in the realm of conjecture and anxiety than reality, but needs to be monitored. It is possible that conventional wisdom has juxtaposed cause and effect.

Rather than the weakness in the sub-prime market spilling over to hurt the rest of the economy, the pattern of delinquencies and foreclosures suggests the problems of the economy spilled out to squeeze the sub-prime mortgage market. That is to say, the problems seem most intense in those parts of the country that not only did not benefit from the housing market boom, but suffer particular economic challenges, like Mississippi and Louisiana, suffering from the lingering effects of Hurricane Katrina, and the upper Midwest, hurt by the woes of GM, Ford and Daimler-Chrysler.

The risk is that Q1 GDP comes in below 2% and Q2 GDP is only slightly better. The disappointing economic performance and the increased uncertainty which the Fed also recognizes, should keep the FOMC on hold in the second quarter, when it meets twice (May 9th and June 28th). Regardless of what Fed officials say, the market has seen an asymmetrical risk toward a rate cut and this has been clearly reflected in the Fed funds futures strip. We have consistently been more hawkish than the market. There are some indications that the market is coming around. The July Fed funds futures finished the quarter pricing in about a 1 in 4 chance of a rate cut in Q2. The same contract implied more than a 50% chance of a cut at the end of Feb.

The naysayers will begin talking about stagflation. The concept harkens back to the late 1970s when the US experienced double digit inflation and a weak economy simultaneously, something that orthodox economics had thought was nearly impossible. The essence of the argument is that policy makers are caught between Scylla of weak growth and the sub-prime problem and the Charybdis of high core inflation. Of the two risks, the Federal Reserve has consistently and unequivocally indicated that the risks are greater from the latter than the former.

Part of the reason policy makers may not be emphasizing the weak growth is that the non-inflationary pace of growth has slowed, due to lower productivity and slower labor market growth. Essentially the speed limit of the economy is lower than it was in the late 1990s. Estimates may vary depending on the assumptions, but it looks to be something close to 2.75% now rather than 3.0%-3.25% previously. This is perhaps the importance of the Fed’s reference to resource utilization rates.

Price pressures are likely to prove more challenging. Consider that the Federal Reserve has chosen its own preferred measures of inflation. It has identified the core deflator of personal consumption expenditures as its preferred measure and several officials have indicated that 2% is the top end of their comfort zone. Yet the PCE deflator has not been below 2% for nearly three years. Even though price pressures do not appear to be accelerating, the concern is that they have been elevated for so long, that businesses, investors, and workers will embed higher inflation into their decisions. This is reflected in the fact that the break-even for 10-year TIPS finished March with its highest monthly close since last August. Over the course of March, the 2-10 year US yield curve steepened by 14 bp to once again be positively sloped. To get price pressures back into the comfort-zone may require tighter monetary policy and/or slower growth than the US is experiencing.

The performance of the euro-zone economy stands in stark contrast with the US economy. Recall that Q4 06 was the first quarter in nearly 5 years that the euro-zone economy expanded faster than the US economy. It looks like it did so again in Q1 07. The ECB has also identified 2% as their inflation ceiling. The flash reading for March shows inflation has been below that level for the seventh consecutive month. The ECB has also warned that price pressures may increase later this year and warned of downside risk to growth in the medium term.

The market fully expects the ECB to hike rates in Q2. Most forecasts are for a move in the May-June period. It makes little difference to longer term investors, as opposed to speculators, exactly when the hike is delivered. The press conference that follows next week’s ECB meeting may help the market fine tune the expectation. Generally speaking, the risk is that by the end of Q2, the ECB has brought its refinance rate to a level that it regards as neutral (4%) and may pause and wrestle with the same dilemma that the Fed does—how to pause without signaling the end of the cycle.

This analysis warns that there is potential in Q2 for the euro to re-test its historic high against the dollar set at the very end of 2004 near $1.3660. In the short-run, long euro positions appear to be a crowded trade as the Commitment of Traders show net speculative long positions to be near-record levels. However, as the market has learned in the discussions of the yen-carry trades, the currency futures market is a small fraction of the spot market and new record positions continue to be set. By most measures of fair value, the euro is already over-shooting, but on an historical basis, the overshoot still seems modest.

If the Federal Reserve is right and the economy strengthens in H2, then the second quarter could mark an important high for the euro. In the last couple of quarters the euro has had a range of 6-7 cents. The analysis presented suggests a range in Q2 of something like $1.30 to $1.37.