Europe
Bumping Along Below Par
March 12, 2010

By Elga Bartsch & Daniele Antonucci | London

As we had expected, the euro area is underperforming many of its peers in terms of growth. The main reason for this underperformance is that more than in most other developed economies the recovery in the euro area is shaping up to be jobless and creditless. For a detailed analysis of these two factors, please see On Labour Market Dynamics and Their Consequences, October 20, 2009 and Credit Crunch vs. Creditless Recovery - The Risks, January 11, 2010. But now even our below-consensus expectations seem too optimistic in light of the incoming data (see Transition Towards a Tepid Recovery, January 4, 2010). On the back of disappointing 4Q GDP reports and concerns about the unusually cold winter weather weighing on 1Q, we are cutting our full-year GDP forecasts for 2010 from 1.2% to 0.9%. This compares to a consensus among market economists of 1.2% and an ECB staff projection of 0.8%. Our full-year forecast for next year remains unchanged, at 1.1%, though. This also leaves us below most official forecasters, who are shooting for around 1.5%, and most market economists, who are projecting 1.6%.

The downward revision in our forecasts largely stems from disappointing dynamics in domestic demand. While we never harboured high hopes for euro area domestic demand, we now pencil in a further small contraction in 2010. At the same time, a weaker euro caused us to raise our estimates for the growth contribution coming from net export demand by two-tenths of a percent.

There is no mistaking the weak domestic demand across the euro area. While overall euro area consumer spending fell slightly in 4Q, investment spending contracted markedly again after a temporary bounce in 3Q. We expect this weakness in domestic demand to continue in 1H10 on the back of deteriorating labour market conditions, low capacity utilisation rates and relatively tight credit conditions. Only in the second half of the year do we expect this weakness to give way to a modest recovery. 

Notably, consumer spending will likely move deeper into negative territory in early 2010, we think, as the payback from the French car-scrapping scheme expires in January. We also expect an ongoing retrenchment in construction activity in 2010, especially in the first few months of the year when the unusually cold winter weather temporarily added to the downward pressure. Investment in machinery and equipment is likely to stabilise as corporate profits, business sentiment and capacity utilisation rates recover. We might even see some small gains, reflecting repair and replacement needs. 

After putting in quite a spurt in the second half of last year, exports of goods and services should continue to show decent growth rates, but at a more moderate pace. It is still too early to expect the weaker euro to boost export performance in early 2010. By contrast, the slowdown in global growth and hence trade volumes is likely to dominate in the near term. As we had feared, the transition from an export-induced turnaround in the industrial inventory cycle toward a sustained recovery in domestic demand remains bumpy, the rate of expansion below par, and the domestic demand recovery brittle.

‘BBB recovery' is not just choppy in terms of headline GDP. It is also uneven among different countries. In 4Q09, France was the only country among the larger euro area countries that expanded at all. Over the same period, the German economy stagnated and both the Italian and the Spanish economies contracted mildly. In France, it was mainly consumers pulling forward car purchases ahead of the expiry of the car-scrapping scheme that boosted consumption and hence overall GDP growth. In Germany, by contrast, consumer spending fell sharply again between October and December, having already retrenched markedly between June and September. Investment spending also fell back into negative territory. Only net export demand saved the day, lifting overall GDP by 2.2pp - thanks also to an outright contraction in import demand. For more details on our country forecasts, please see Global Forecast Snapshots, March 10, 2010. 

The uneven nature reflects different factors, we think. First, the timing of withdrawal of policy stimulus (notably the car-scrapping schemes) and its impact on consumer spending. Second, the size of the housing market correction and its repercussion on construction activity. Third, net foreign demand and its contribution to overall GDP growth. As usual, net export demand partially reflects domestic demand dynamics, which is a key driver of import demand. But it partially also reflects the export performance per se. Currently, we observe a stronger revival in demand from outside Europe, which is benefitting countries that send a larger share of their exports overseas (e.g., Germany and also Italy). Fourth and finally, the inventory cycle seems to be at different stages in different countries. Further aggressive destocking weighed on 4Q GDP in Germany, while less aggressive destocking boosted GDP considerably in France. While we are always wary of reading too much into the inventory dynamics because it is essentially a residual between the production dynamics and the demand components in the national accounts, we observed a shift in companies' inventory management in this cycle.

In our view, something unusual is going on in industry in the euro area, notably the inventory cycle. We first highlighted a new pattern emerging in the inventory cycle a year ago (see Inside the Inventory Cycle, February 23, 2009). It seems that manufacturers embarked on a very aggressive cutback in inventories in the course of the downturn. These cutbacks reinforced the recession and, in our opinion, were a key reason for the unprecedented decline in activity globally. The aggressive destocking caused companies' inventories to turn around much earlier and more quickly than their order books - a clear deviation from the close co-movements between both series observed historically. Contrary to our initial expectation, the gap between orders and inventories (which has widened to more than two standard deviations) has not closed yet. If anything, those hoping that the gap would close by order books catching up with inventories were disappointed. Instead, companies are now reassessing the inventory situation and have reported no further gains in current production. The slippage in the survey data is even more surprising, given the strong growth momentum in industrial activity abroad and the recent weakening of the euro's external value. 

It might be that we are observing a regime shift in inventory management in the manufacturing industry. Two factors could have caused such a regime shift: First, the widespread use of just-in-time management and globally integrated production chains made this the first fully technology-enabled global recession. It seems that companies have reacted much faster to a shortfall in demand in this last downturn than they have ever done before, causing inventory levels to be very low by historical comparison. Second, credit availability became a concern for many companies as soon as the financial crisis set in. Against this backdrop, worries about the ability to fund an inventory overhang have likely reinforced the destocking process. As a result, the inventory cycle acted as an accelerator during the downturn (rather than a buffer between production and demand). Therefore, we will be watching the inventory cycle very closely in the coming months to assess whether it also could act as an accelerator in the upturn.

Our surprise gap index declined sharply and could soon become negative for the first time since February 2009. If the index, which measures to what extent companies are surprised by recent production trends compared to their own expectations three months ago, fell deep enough into negative territory to break through the lower bound of the neutral range, our business cycle compass model would start to signal the risk of a renewed downturn. In this case, a double-dip could no longer be excluded in the euro area. For now, however, our proprietary indicators point to an ongoing recovery with rather meagre GDP growth rates. Our GDP indicator - both the top-down version based on euro area data and the bottom-up version based on country dynamics - points to 0.2%Q GDP growth in 1Q and puts the first sighting shot for 2Q in the range of 0.3-0.5%Q. If the surprise gap index started to surge again, this could be an indication that some upside surprises in growth could be in the making in the spring. 

It is important to note that the weakness observed in the manufacturing sector is manifesting itself before any fiscal austerity measures in the euro area periphery have even been implemented. Contrary to some of our colleagues and clients, who are concerned that these fiscal austerity measures could drag down euro area growth, we don't think that the fiscal policy tightening in the periphery is sizeable enough to have a meaningful impact on overall Euroland growth for two reasons. First, the small size of these countries (Greece, Ireland, Portugal and Spain together account for 17% of the euro area). Second, the expansionary fiscal policy stance pursued in the core countries. What worries us more at this stage is the weakness in the core countries. EMU-wide fiscal consolidation is a story for next year.

The ECB prepares a gradual exit from the extra-expansionary policy stance. Against the backdrop of a gradual sub-par recovery and muted inflationary pressures, there is no rush for the ECB to raise interest rates, we think. When the weaker euro and the elevated commodity prices feed through into higher consumer prices next year, we expect to see headline inflation back at the ECB's price stability norm based on our upwardly revised inflation forecast, which now stands at 1.8% compared to 1.5% before. Given its preference for gradual and predictable moves, the ECB is fully aware that it will take quite a while to get from the present extra-expansionary policy stance towards a neutral range of interest rates between 2.75% and 3.25%.

As a result, the ECB will likely move as soon as it deems the recovery in domestic demand is secure and the bank lending cycle has turned around. While we still expect the ECB to raise rates before year-end, we have pushed the timing of the first rate hike back by one quarter and now look for a first rate hike in 4Q10. Note that the absence of inflationary pressures over the forecast horizon is no reason not to raise rates. Indeed, if there were some inflation concerns over the policy relevant horizon of 12-18 months, this would require a monetary policy stance that is outright restrictive rather than one that is a little less expansionary than before (see Eurotower Insights: Taylor-ing Rates for the Exit, July 29, 2009).

Ahead of any hike in the refi rate, the ECB will gradually withdraw term-funding.  As previously announced, the ECB confirmed at the March Governing Council meeting that it will phase out both the one-year and the six-month tenders. While the last one-year tender was held in mid-December, the final six-month tender will take place at the end of this month. Like the December one-year tender, the last six-month tender will be offered at a tracker rate, which, from an interest rate perspective, should make banks indifferent between bidding for term funding and rolling over weekly MROs. 

In addition, the ECB announced that its three-month LTROs will revert back to competitive auctions as soon as the late April tender. While this implies that all bids for three-month funding will no longer be filled automatically, the ECB has made it clear that it will manage the liquidity in the LTROs with a view to "ensuring smooth conditions in money markets and avoiding any significant changes between bid rates and the prevailing MRO rates". Contrary to earlier LTRO auctions, held until October 2008, the ECB is introducing a minimum bid rate to the LTRO. Hence, LTRO cannot fall below 1%. Historically it has sometimes dipped below the refi rate when the ECB was in easing mode. The average spread of long-term refi rate over the refi rate since the start of EMU has been about 15bp; in tightening cycles, however, it tended to be higher, averaging about 30bp.

For now it still offers unlimited funding at weekly and monthly maturities. Finally, the ECB committed to leave its weekly MROs and its monthly Special Terms Refi Operations (STRO) at fixed rates with full allotment at least until the maintenance period ending on October 12. At this stage, the ECB has no intention of managing the EONIA overnight rate closer to the refi rate. If EONIA creeps higher over this timeframe - for instance, when the jumbo one-year tender rolls off at the end of June or when the last six-month tender expires at the end of September - this would entirely reflect the lower bids submitted by the banking system. Managing the EONIA overnight rate higher starting in October by ending full allotment would be consistent with a first refi rate hike in December. 

To sum up, the gradual withdrawal of liquidity by the ECB will cause the average maturity of the funding available to the banking system to decline. As a result, we would expect the MROs to regain in importance, even though we expect both the STRO and the three-month LTRO to be well bid too. As the ECB stops offering longer-dated funding, the respective EURIBOR rates have moved back above the refi rate, pushing up funding costs for banks and indirectly costs of capital. At the same time, the ECB leaves the safety net that is the full allotment process in place for weekly MROs and monthly STROs. In the autumn, the ECB will need to decide whether it can afford to remove this safety net, which guarantees unlimited liquidity to eligible counterparties, or whether it needs to actively intermediate the interbank markets (see EuroTower Insights: Executing the Exit, November 11, 2009).

Expect ten-year Bund yield to rise above 4% this year, a marked rise from the current level of 3.12%. While we shaved a few basis points off our year-end target for ten-year bond yields to reflect the changes to our growth outlook and our ECB call, we still see several factors pushing bond yields higher this year. First, the market is not priced for an ECB rate hike before year-end. Second, thus far fiscal austerity is not meaningful for the euro area as a whole. And it remains to be seen whether Germany, France and Italy really embark on a belt-tightening exercise next year. Third, the full extent of the sovereign crisis in the wake of the financial crisis spreads from periphery to the core. Potential solvency issues at the periphery could cause dilution of credit quality at the core (see Greece and Euro: Between a Rock and a Hard Place, February 22, 2010). Within the euro area the sovereign risk is mainly a credit risk, given that the ECB is not allowed to fund governments directly. Globally, however, it will likely morph into an inflation risk, given that the US and the UK governments have the possibility to fund budget deficits at the central bank directly and also have the incentives and the means to lean on their central banks to tolerate inflation overshoots in an attempt to deflate the debt burden (see Global Monetary Analyst: Debating Debtflation, March 3, 2010). Bond markets, where many market participants are still fretting about deflation, are not priced for rising inflation pressures in some of the world's largest economies. Fourth, the global environment will become less bond-market friendly once some of the concerns that have spooked equity investors (notably the rollover of the leading indicators and the start of monetary policy tightening) blow over.

There is one important wildcard to our bond yield call: the unwinding of the ECB's unconventional policy stimulus measures. Once the ECB starts to get back in the driving seat as far as liquidity is concerned - by moving away from full allotment in the MROs and the STROs - there could be potential repercussions on the indirect quantitative easing (QE) via the banking system that has characterised the ECB strategy in expanding its balance sheet in reaction to the crisis. By offering generous liquidity to the banking system - in terms of the interest rate, the size of the funds available and the collateral against which it lends - the ECB induced euro banks to load up on government bonds (about €350 billion were bought since the start of the crisis). Here, any liquidity withdrawal together with any regulatory changes looming over the coming years - notably about liquid asset buffers - as well as risk-management considerations could affect the way in which banks will manage their balance sheets.    

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United States
Review and Preview
March 09, 2010

By Ted Wieseman | New York

Treasuries posted significant losses across the curve over the past week as the key early run of economic data for February indicated that the economy held up a lot better than expected during the severe snow storms, pointing to more underlying momentum that we anticipate will show up in a notable rebound in activity in coming months.  The market was also hit by upward pressure on repo rates and effective fed funds and a reduced flight-to-safety bid as fears about Greece's fiscal situation eased substantially following the passage of additional budget tightening measures and the successful sale of a 10-year issue.  Even with what appears to have been a significantly bigger negative impact from weather and a smaller offsetting boost from census hiring, payrolls only fell 36,000 in February, and the jobless rate was steady at 9.7%.  We think that payrolls probably would have risen more than 100,000 excluding snow disruptions, and it now looks increasingly likely that the unemployment rate peaked at 10.1% in October.  Our early baseline for March payrolls is for a 300,000 gain, including 100,000 temporary census workers.  The surprisingly resilient employment report came after strong results from the ISM surveys - manufacturing down somewhat but to a still quite robust level and non-manufacturing rising to a more than two-year high - and upside in early consumer spending indications that pointed to a solid February retail sales report.  Softer data for January on construction spending and capital goods orders and shipments and some negative impact on February activity still from weather led us to cut our 1Q GDP forecast to +2.0% from +2.2%, but it's increasingly looking as if we could see a fairly strong snapback in 2Q, and we think growth will rebound to near +4%. 

Meanwhile, short-term financing and policy rates saw some notable upside over the past week, with the main driver being an immediate impact from the ramping up of SFP bill issuance, the most significant step the Fed has implemented yet in moving towards an exit from its super-easy monetary policy.  The US$45 billion in additional SFP bill issuance in the past couple of weeks comes on top of a seasonal shift to higher regular bill issuance during peak tax refund season and heavy ongoing coupon supply every couple of weeks.  The big boost this has provided to Treasury supply and thus Treasury collateral available in the repo market drove the average overnight Treasury repo rate up to 0.19% Friday from around 0.10% in the days before the SFP announcement, and effective fed funds traded up through the week to near 0.17% Friday after a lengthy period near 0.12%.  In addition to the boost from rising repo rates, the effective fed funds rate was also lifted by anticipation of falling cash balances at the GSEs as Fannie and Freddie are moving aggressively to buy delinquent mortgages out of MBS pools.  Because they trade in the fed funds market but by law can't be paid interest on their Fed balances since they aren't depository institutions, the home loan banks and Fannie and Freddie are key drivers of the gap between effective fed funds and the 0.25% interest rate being paid on excess reserves.  So if GSE cash falls and shifts to banks as investors deposit the proceeds from MBS prepays, the gap between effective fed funds and the rate on reserves could be sustainably narrower than the 13bp seen fairly consistently over the past couple of quarters.  Upside in repo rates and fed funds effective also was felt in the FX swaps market, with upward pressure on the implied dollar Libor rate there, and this helped give the dollar a boost on the week even as investor fears about Greece eased considerably.  The spread of Greece's 2-year debt over German bunds narrowed about 140bp on the week to near 380bp, more than reversing a 100bp widening over the prior couple of weeks to move the spread to its lowest level since late January.  Even with German and some EU government officials claiming that there was no imminent plan to announce a support plan for Greece, press reports indicated that discussions were ongoing behind the scenes on such a proposal.  And prospects for such a step seemed higher after Greece passed substantial new budget reduction measures that could lower its deficit to below 9% of GDP this year from almost 13% last year.  On top of the less negative sentiment on Greece, US rates markets were rattled a bit (more so than Europe it seemed actually) by somewhat earlier-than-expected further moves by the ECB to wind down its emergency liquidity injections, with an announcement after Thursday's meeting that the last 6-month refi operation would be at a variable rate (so if the ECB decides to hike rates within the next six months, the rate on the borrowing would go up) and 3-month operations would shift to auction from full allotment next month.  US markets may have been more rattled by this shift than European markets since it came just as investors here were starting to focus closely on recent upside in US financing rates, and certainly these moves in Europe could add to similar further upside in Europe too.  Interestingly, Japan may be heading in the other direction, with the BoJ potentially ready to consider additional easing measures, in line with the expectations of our Japan economics team (see BoJ Watch: Nikkei Article on BoJ Easing: Direction Clear, Timing Murky by Robert Feldman and Takehiro Sato, March 5), and the yen sold off sharply late in the past week as Japan money market rates eased while US short rates were rising. 

On the week, benchmark Treasury yields rose 6-11bp, with the intermediate part of the curve significantly outperforming, as the front end was hit hardest by the financing rate pressures, the long end was pressured by upcoming supply, and the belly seemed to find some support by dislocations in mortgages and swaps.  Weakness in response to Friday's strong payrolls data though resulted in a bear steepening sell-off and big widening in TIPS breakevens, so investors seemed to be showing some cautiousness about whether the Fed would respond appropriately to an improving economic outlook.  The 2-year yield rose 10bp to 0.90%, 3-year 8bp to 1.41%, 5-year 6bp to 2.34%, 7-year 7bp to 3.10%, 10-year 9bp to 3.69% and 30-year 11bp to 4.64%.  By holding about unchanged, TIPS solidly outperformed, with most of the upside in inflation expectations coming Friday.  TIPS were also helped by a strong week for commodity prices, which performed unusually well as the dollar index rallied a bit (gaining significantly against the yen, ending up about unchanged versus the euro after a lot of volatility, but selling off substantially against the Canadian dollar).  Improved optimism on growth added to fears about the impact of the earthquakes in Chile to lift metals prices in particular, with the LME's industrial metals composite index up 5% to just below the prior recent high hit in early January.  Energy prices were more sensitive through the week to the dollar but still ended up with good gains, with April oil up US$1.84 a barrel (+2%) to US$81.50 and April gasoline gaining US$0.08 a gallon (+4%) to US$2.27, a new high for the front month since autumn 2008 as we move into a seasonally elevated period for gasoline prices.  The 5-year TIPS yield fell 1bp on the week to 0.19%, 10-year rose 1bp to 1.46% and 30-year rose 3bp to 2.15%.  This lifted the benchmark 10-year inflation breakeven 8bp to 2.22%, reversing the majority of the prior week's 14bp decline. 

There were some unusual and volatile moves in swaps and mortgages through the week and some substantial politically driven volatility Friday in agencies - but rates volatility actually declined substantially through most of the week and saw only limited upside during Friday's market sell-off.  Swap spreads continued moving lower through Thursday before widening back a bit in Friday's sell-off.  For the 10-year spread, this resulted in a series of record-low closes through much of the week, with an intraday move below 2bp before an all-time low close of 3.25bp Thursday and then a partial reversal to 4.25bp at Friday's close, which represented a halving from the 8.5bp at the end of the prior week.  There was some swapping of corporate issuance at times during the week, but the spread narrowing seemed more to be driven by stop-outs of long spread trades.  Meanwhile, the MBS market was thrown into some turmoil as market participants tried to figure out the impact of Fannie Mae's Monday announcement that it would buy 150,000-200,000 delinquent mortgages out of its MBS pools in March.  The initial interpretation of Fannie's statement was that buying would start in higher coupons and then work down, and higher coupon MBS sharply outperformed early in the week in response, but this assumption was thrown into question mid-week after Fannie released a servicing guide update that suggested a more even distribution across the coupon stack (see GSE MBS and Debt Weekly Overview: Fannie Buyouts Get Murkier by Janaki Rao, Bernard Gordon, and Zofia Koscielniak, March 5, for details and their revised estimates of the impact on prepay speeds).  After a lot of volatility across the coupon stack during the week as investors tried to adjust to this uncertainty, mortgages significantly outperformed Treasuries broadly, with help from falling interest rate volatility, the lagging volatility moderated somewhat to widen several bp on a Libor OAS basis.  Lower-coupon MBS still ended up lagging higher coupons a bit on the week, but current coupon yields ended up about unchanged near 4.33%, in the middle of a stable recent range that has kept 30-year conventional mortgage rates very close to 5% for the past couple of months.  Amid some of the seemingly volatile moves in different rates markets, a big drop in implied volatility was impressive.  This made more sense early in the week as Treasury yields were barely moving, but there wasn't much of a reversal at all Thursday and Friday when they did see some big gyrations.  On the week, 3-month x 10-year normalized swaption volatility declined 10bp to 93bp, only rising 1bp Friday from the lowest reading since late 2007 hit Thursday. 

Risk markets ended up posting good gains on the week, largely as a result of decent rallies Friday.  Volatility in stocks and credit was quite low through the week, and this seemed more appropriately reflected in a big drop in the VIX, which fell to 17.5% Friday, a low since autumn 2008, from 19.5% at the end of the prior week, than the surprising stability of rates volatility near the lows late in the week.  The S&P 500 gained 3.1% on the week to move back into the green for the year by 2.1%.  The best-performing equity sectors on the week were materials, boosted by the metals price surge, and consumer discretionary, helped by the surprisingly strong chain store sales results.  Credit is still lagging stocks so far this year, but big gains late the past week at least erased prior losses.  In late Friday trading, the investment grade CDX index was a strong 7bp tighter on the week at 85bp, which is where it ended 2009.  The high yield CDX index was 17bp tighter at 552bp through Thursday but a gain of more than a point Friday also got it near 2009's closing spread of 518bp.  Performance by the commercial real estate CMBX market continued to be mostly comparatively quite poor.  A 1% gain on the week by the AAA index left it flat for the year, but a 3% rally by the junior AAA index still left it down 10% so far in 2010, and the AA index was down another 1% in the latest week to extend its year-to-date plunge to 11%. 

Non-farm payrolls fell only 36,000 in February even with what appeared to be a big negative impact from weather and significantly smaller-than-expected 15,000 offsetting boost from census hiring.  The number of people in the household survey saying they weren't at work during the survey week because of the bad weather soared to 1.1 million, the highest February on record and second-highest of any month in the past 28 years after only the ‘Storm of the Century' in January 1996.  We estimate that this points to a 150,000 drag on payrolls from weather.  So excluding weather and census, we estimate that underlying job growth was close to +100,000, a significantly better outcome than the flat reading we expected.  Growth continued to be particularly strong in temp hiring, which gained another 48,000 in February for a record 44% annualized surge since October - a positive leading indicator for permanent job growth going forward.  Manufacturing jobs also managed a small 1,000 further gain on top of a 20,000 rise in January.  Rising manufacturing jobs has been an infrequent occurrence since the late 1990s and this upside reflects how strong the recent growth in this area has been as it has led the economy out of recession.  The manufacturing ISM employment gauge moved above the 50-breakeven line in October and reached its best level since 2005 in February.  On top of permanent gains to factory jobs the past couple of months, a good portion of the record surge in temp employment since October has probably been attributable to the manufacturing sector.  On top of the recent upside in temp hiring, a good result for the workweek was also a positive leading indicator.  The average workweek only fell a tenth to 33.8 hours, a smaller impact than we've seen in prior major weather-impacted months, and it seems likely to move up to a new cycle high of 34 hours or higher when weather impacts are reversed in March.  Meanwhile, the unemployment rate was steady at 9.7% on another big gain in the household survey employment measure.  It now looks increasingly likely that the unemployment rate peaked at 10.1% back in October.  Looking ahead to March, our initial baseline expectation is for a 300,000 gain in non-farm payrolls including a 100,000 boost from census hiring, which would result in an average 75,000 gain in ex-census hiring in February and March. 

Both ISM surveys showed robust results in February, with non-manufacturing starting to close the gap with the manufacturing sector that led the economy out of recession.  Upside in the employment gauges was the most notable part of both reports.  The composite manufacturing ISM index fell 2 points in February, but to a still quite strong 56.5, the second-best reading after January since late 2005.  The orders (59.5 versus 65.9) and production (58.4 versus 66.2) gauges saw significant pullbacks from unusually strong readings in January but still held well above the 50-breakeven level, while the employment gauge (56.1 versus 53.3) surged to a five-year high.  Low inventories continued to support output.  Respondents continued to gradually slow their inventory liquidation, with the inventory index up a point to 47.3, while the customers' inventory gauge rose 5 points but remained at a very low 37.0, with a third of respondents saying their customers' inventories were too low and only 7% too high.  Meanwhile, the composite non-manufacturing ISM index surged to 53.0 in February from 50.5 in January, a high since December 2007.  The business activity (54.8 versus 52.2) and orders (55.0 versus 54.7) moved solidly into growth territory, and the employment index (48.6 versus 44.6) improved to its least negative outcome since early 2008. 

Despite widespread reports of a significant negative weather impact, early indications for February consumer spending were surprisingly positive.  Motor vehicle sales declined to a 10.3 million unit annual rate in February from 10.8 million in January, which was a fairly good result actually considering that industry sources estimated that sales might have been reduced by about 700,000 by weather and 300,000 by Toyota's recalls.  Major retailers also broadly reported a significant hit from weather but still managed to report significantly better-than-expected chain store sales results for February, with aggregate comp store sales growth accelerating to the strongest rate in three years (excluding a few months that were distorted by holiday timing shifts).  Clothing, department, club and discount retailers all posted good gains in sales.  Incorporating this upside, we boosted our 1Q consumption estimate to +3.0% from +2.8%.  Weaker-than-expected construction spending results in January, which will likely carry into February given the weather, and negative revisions in the factory orders report to the pullbacks in capital goods shipments and orders figures in January after big gains late last year, however, offset this upside and left our 1Q GDP forecast to +2.0%.  We think that this figure is likely to be depressed by weather and also by paybacks from activity accelerated by the homebuyers' tax credit that initially was scheduled to expire at the end of November and the accelerated depreciation schedules that expired at the end of December.  As the weather improves and the tax-driven payback fades, we look for GDP growth to double to +4% in 2Q (see Richard Berner's March 5 note, US Economics: Payback Here, Snapback Coming, for a full discussion). 

The economic calendar is light in the coming week, with focus on the retail sales report Friday.  Prior to that, it's another heavy Treasury supply week, with a US$40 billion 3-year auction Tuesday, US$21 billion reopening of the 10-year Wednesday, and US$13 billion reopening of the 30-year Thursday.  Ongoing developments in repo and fed funds markets and any comparable developments overseas are likely to remain in focus, and any news on the Greece situation will also be watched for.  Data releases due out include the Treasury budget Wednesday, trade Thursday and retail sales Friday:

* We expect the federal government to report a US$220 billion budget deficit for February, about US$25 billion wider than in the same period a year ago, reflecting the ongoing impact of the Making Work Pay tax credit, an increase in cyclically sensitive spending items such as unemployment insurance, and rising outlays for grants to state and local governments.  On the positive side, corporate profits taxes jumped about US$7 billion, and receipts from the Federal Reserve increased US$6 billion.  For the fiscal year as a whole, we still see the budget deficit tracking at US$1.325 trillion or about 9% of GDP.

* We look for the trade deficit to widen by US$1 billion in January to US$41.0 billion, with exports down slightly and imports up marginally. These swings would represent some flattening out on the heels of the steady increases seen over 2H09.  On the export side, industry figures and factory shipments results point to softness in capital goods concentrated in a pullback in aircraft from a lofty December reading.  Upside in industrial materials helped by higher prices should provide a small boost.  On the import side, oil imports should be little changed as a moderation in volumes after a surge in December should offset a gain in prices, while port data also point to little change in non-energy goods imports after a big prior run-up. 

* We forecast a 0.3% gain in February retail sales, overall and ex autos.  The February chain store reports pointed to solid gains in discretionary categories, such as general merchandise and apparel. Moreover, we look for a pick-up in categories such as pharmacies and grocery stores. Also, even though unit sales of motor vehicles edged down in February, our model points to a slight uptick in the auto dealer component of retail sales. Meanwhile, gas prices were little changed on a seasonally adjusted basis and bad weather in parts of the country likely kept some drivers at home. So, we look for a flat reading for the service stations category.  On the downside, we are factoring in some significant weather-related declines in sectors such as home electronics, furniture, hardware, sporting goods and restaurants. Still, the key core retail control item that factors directly into the calculation of personal consumption spending is expected to be +0.5% for the month, which puts our tracking estimate for 1Q consumption at +3.0%.

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