UBS Expects Positive Q2 Growth, Negative Q3

(RTTNews) - Along with Q2 data, the GDP report will incorporate the annual revision, covering the past three years. Growth probably remained weak but positive in Q2, say the analysts at UBS. The Employment Cost Index (ECI | Quote | Chart | News | PowerRating) likely showed slowing in Q2. We forecast a decline in the Chicago PMI. Jobless claims have been volatile recently. After a 34k jump to 406k in the latest week, we expect only a partial reversal, to 390k (cons 393k).

The ADP estimate of private payrolls rose 9k, above the -40k consensus. The trend in government payrolls is around +20k per month, so taken literally +9k for private implies around +30k total, well above the -75k consensus and UBS estimate for total payrolls in Friday's report. However, the ADP data have been unreliable in signaling what to expect in the official payrolls data recently: Over the last eight months the ADP data have overstated private payrolls by 103k per month on average. The housing affordability index fell to 119.2 in June from 125.7 in May. The weekly mortgage applications survey showed a drop in fixed mortgage rates in the latest week: 30-year fixed rates fell 12bps to 6.46%, but are still up from averages of 6.07% in Q2 and 5.84% in Q1. 15-year fixed rates fell 12bps to 5.98% but are up from 5.62% in Q2 and 5.28% in Q1. 1-year ARM rates continued to surge, rising 9 bps to 7.25%, versus 6.92% in Q2 and 6.11% in Q1.

"In light of continued fragile markets," the Fed announced a number of additions and extensions to its existing liquidity facilities. This was not a surprise. However, the expanded liquidity provisions highlight the fragile market conditions that, we think, make it highly unlikely that the Fed will tighten policy any time soon. Fed fund futures are pricing in a high chance of the Fed raising rates this year, whereas we still expect two 25 bps cuts in the funds rate to 1.50% by year end. The Fed extended the Primary Dealer Credit Facility (PDCF | Quote | Chart | News | PowerRating) and the Term Securities Lending Facility (TSLF | Quote | Chart | News | PowerRating) through January. The Fed will also offer options for primary dealers to borrow treasuries through the TSLF. The options will be offered "in advance of periods that are typically characterized by elevated stress in financial markets, such as quarter ends". Details of this plan are still being worked out. The Fed also will begin offering longer maturity (84 day) TAF, to 84-day lending as a complement to its 28-day lending.

Treasury Department officials did not announce any immediate changes to their auction schedule but indicated that they are considering expanding 10-year note auctions to 12 per year (from eight per year) and 30-year bond auctions to four new issues per year (from two new and two smaller re-openings currently). Any changes will be announced in November. The upcoming 10-year auction was raised to $17B from $15B at the last auction, and the 30-year auction was raised to $10B from $9B.

At 383,000, the latest four-week average in initial claims is little changed from 379,000 four weeks earlier. However, we believe the seasonal adjustment factors allowed for too large an increase in filings related to temporary summer shutdowns in the auto industry in the first two weeks of July—too large because of downsizing in the auto industry in recent years. Nor should such a distortion be offset by above-trend readings in later weeks. (The filings were lower than the seasonal factors allowed for—they were not delayed.) The implication: the jump in claims to over 400,000 in the week of July 19 could well reflect a still-rising trend. The monthly employment report generally has not been as sensitive as the claims data to the size and timing of summer shutdowns in manufacturing.

In the annual revision, Bureau of Economic Analysis (BEA | Quote | Chart | News | PowerRating) officials incorporate more complete data than were available as each quarter was reported. Revisions to initially reported quarterly growth rates can be substantial, although we doubt officials have enough new data yet to make significant changes to the last couple of quarters. Real GDP is currently reported to have increased weakly in Q407 and Q108. Similarly, we expect the Q2 data to show a weak but still positive growth rate (1.0% at an annual rate), even with a sizable drag from inventories. Net exports likely added significantly to the reported pace in final sales. Real domestic final sales likely rose weakly. Real consumer spending likely increased in Q2 as a whole, likely helped by the tax rebates. However, it appears to have lost momentum as the quarter ended, with the June level below the Q2 average. We expect real consumer spending and overall real GDP to decline in Q3 (at annual rates of 1.5% and 1.0%, respectively).

Wage gains have already shown some slowing: the 3.2% y/y pace for private wages and salaries in the ECI in Q1 was down from 3.5% y/y a year earlier. Average hourly earnings in the employment report have slowed to 3.4% y/y in June from 3.7% at the end of 2007 and 4.3% y/y at the end of 2006. The deceleration implies that downward pressure from the rising unemployment rate has more than offset any upward pressure from higher inflation expectations as oil prices have surged. We expect that pattern to persist as the unemployment rate continues to rise. The importance of wages in the potential transmission of inflation expectations into actual inflation was emphasized by Mr. Bernanke in his latest Congressional testimony.

The housing affordability index rose sharply, on balance, in Q4 and Q1, but has been falling since then, mostly because of rising mortgage rates. The index remains above its average levels in 2007 (112 | Quote | Chart | News | PowerRating) and 2006 (106 | Quote | Chart | News | PowerRating), although the apparent improvement is suspect as the index does not reflect the impact of tighter mortgage lending standards.

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