The Economy and Mortgage Market
The US economy turned in a strong third quarter, which only served to heighten expectations for proof that the recovery was here to stay. Third quarter GDP growth-finalized at 8.2%, the highest since 1984-was generally agreed to be an exceptional performance, the result of the full effects of accommodative fiscal and monetary policy. Most economists pointed to the string of mostly positive news released during the fourth quarter as evidence to support their increasingly bullish positions. At the turn of the New Year, however, ominous signs began to arise. The preliminary GDP estimate for the fourth quarter came in at 4%, below expectations. Also falling short was the employment report released January 9, which was so far below expectations that most economists suspected something was wrong with the data. The report detailed that the US added just 1,000 jobs in December, well below the consensus of 150,000. The unemployment rate fell to 5.7% from 5.9%, but only because 309,000 people withdrew from the job market. Ian Morris, economist at HSBC bank, said that if the participation rate had not declined, “the true unemployment rate is more like 7%.”

During an economic recovery, the US would typically be adding jobs at a much swifter rate. Many observers have compared past experience to today: For example (thank you, Mort Zuckerman), if past recoveries are any guide, two years after the bottom of a recession the US would have added 7.7 million jobs; instead, the US has lost 2.5 million manufacturing jobs. Wages are usually 8% higher two years after a recession; this time around wages are down nearly 1%. The favorite culprit in trying to explain why it is different this time is productivity. Nonfarm productivity-the output per hour of all workers in the nonfarm business sector-increased 9.40% for the third quarter, the highest increase in almost 20 years, as companies generated their strong performance without resorting to any additional hiring.

Productivity is only way to describe what is happening. A discussion of missing jobs in the US would be incomplete without a stop at the People’s Republic of China. Many of the manufacturing jobs that have been lost over the past two years have been lost to China and are not coming back. Why? China is becoming the manufacturing floor of world, because it is the low-cost option for manufacturers. According to the Wall Street Journal, the average plant worker earns approximately $80 per month, a fraction of what a US worker makes. Interestingly, two of the top 10 exporters from China are American companies-Motorola and Seagate-which means that these companies (and others setting up manufacturing operations in China) are lowering their cost structures and increasing profitability while not having to hire new employees. The surging importance of China as a manufacturing center explains not just the employment challenges in the US, it also helps explain the weak pricing power that has led to America’s deflationary undertow. To express it bluntly, in a global economy, manufacturing activity goes to the lowest bidder, and that low bidder is typically China and, increasingly for white collar work, India. The US, as the world’s biggest economy, loses the jobs that go along with that activity, but benefits from lower costs of imported goods.

This macroeconomic shift has become an issue in the interest rate and currency markets, too. The trade imbalance between the US and the rest of the world, principally China, and the resulting current account deficit, are a stark reminder of the path the global economy seems to be taking. The US current account deficit for the September quarter was $135 billion, and $542 billion over the last four quarter. In other words, in the United States we consume more than we produce and to meet the demand we import more than we export. To finance this deficit, we receive investment dollars (i.e., we borrow) of approximately $1.5 billion a day in the form of financial assets like Treasurys, Agencies, corporate bonds and stocks. So far, foreign investors have been happy to play their part in this arrangement. The ownership position of foreign investors of US assets is substantial and growing. Non- US investors own approximately 40% of outstanding public debt, up from 20% a decade ago. Over $1.5 trillion in Treasurys, Agencies, corporate debt and equities are owned by foreign investors. According to the Federal Reserve, over the six quarters ending with the second quarter of 2003, the total outstanding US government debt rose by about $345 billion, while foreign holdings of such debt rose by about $304 billion--90% of that amount. Theoretically, this pace of foreign investment could continue indefinitely. But here is the critical point: While anything short of that amount and the deficit would shrink, it would also mean that the assets that have been bought by foreign buyers to fill that hole--primarily financial assets--will shrink in value. Moreover, the foreign countries that have gotten accustomed to selling their products to be consumed in the US and financing our purchase of those products will have to find a replacement for that demand. Both sides of the current account deficit, then, are currently motivated to keep the status quo.

To us, the risk in this arrangement is the sustainability of foreign investors’ desire to finance our current account deficit. Chairman Greenspan said in a recent speech, “In the end, the restraint on the size of tolerable US imbalances in the global arena will likely be the reluctance of foreign country residents to accumulate additional debt and equity claims against US residents.” We don’t think that there will be a particular day when this restraining point arrives. More likely, the change in demand for US securities will be a change at the margin, with many different influences. Clearly, one of the determinants of demand for dollar-based assets is the value of the dollar (please see “It’s a Big World After All: Foreign Capital Flows and the US Markets” on our website). Another is the US federal budget deficit. This week President Bush issued his fiscal 2005 budget, in which he outlined spending and revenue goals for the coming year and beyond. The budget deficit for the current fiscal year is projected to be $521 billion this year. To help finance the deficit, more borrowing is required: The Treasury Department announced plans to borrow a net $177 billion in the current quarter-a record for any quarter. Granted, the current budget deficit would total 4.5% of US gross domestic product, which is less than the record of 5.9% in fiscal 1983 under President Reagan, but some market participants see the increased borrowing as leading to potentially higher market interest rates.

Meanwhile, the arbiter of short-term interest rates, the Federal Reserve, decided on January 28 to maintain the key overnight lending rate at 1.0%. In its release, the Federal Open Market Committee saw a balance of upside and downside risks for growth and inflation. Productivity growth is one of the only bright spots in the economy, with new hiring growth and resource use staying subdued. Therefore, the FOMC “believes that it can be patient in removing its policy accommodation.” In dropping the phrase “considerable period”, which it had used since its August 12 statement to emphasize how long it was willing to stay accommodative, the Fed was perhaps signaling the market that it may be closer to starting the cycle of tightening. We disagree with that interpretation. As we have said in prior commentaries, we believe the Fed will not tighten until it sees significant and sustained job creation and strong evidence of price inflation. At this point in the economic cycle, we still believe that those conditions are unlikely to occur in the near future.

During the month, the 10-year Treasury yield had a high close of 4.381% on January 2, and closed as low as 3.971% after the market reacted to the weak employment numbers release. The move down in rates (the market subsequently closed the month at 4.134%) prompted much discussion in the mortgage market about convexity. This discussion requires a look at the coupon distribution of the mortgage market. This time last year, the ten-year Treasury closed the month of January yielding 3.964%. At the same time, 91.85% of the mortgage-backed securities market carried a coupon of 6% or higher, with 36.82% at 6.5%, the largest coupon. Today, 73.29% of the MBS market carries a coupon of 6% or less, with 31.34% at 5.5%, the largest coupon. In other words, the entire market has shifted down approximately a full percentage point in coupon. Clearly, the run down to 3.07% in the 10-year in the winter and spring of 2003 made the 6.5% and 7% coupons vulnerable. Recall that at that low level in rates, 100% of the mortgage market was refinanceable (defined as the having at least 40 basis points of economic incentive to refinance). Today, the vulnerable coupons are the 6s and 5.5s. The Street is estimating that a move to below 3.70% on the 10-year would make the 5.5s refinanceable. According to Bear Stearns, a move to below 3% would render 93% of the market vulnerable to refinancing. On the demand side, the continued lack of commercial and industrial loan demand has left banks with little choice but to buy securities as their deposits rose. Together, banks and the GSEs own 61% of outstanding mortgages (including raw loans). We will be keeping an eye on anything that could affect this demand source, including deposit growth, loan demand growth, and the effect of any capital constraints on Fannie Mae and Freddie Mac.

At this date, we still have no resolution in the debate over regulation of the GSEs. The possible outcomes at this point are empowering and moving the regulator to under the Department of Treasury, the creation of a new regulator outside of the government, or keeping the current regulator but expanding its powers and budget. We haven’t seen a lot of movement in Congress to begin the difficult work of making this decision, but it is clear that the Bush Administration favors having Treasury in charge. A section in its fiscal 2005 budget is devoted to the subject. “The Administration proposes placing the new regulator within the Department of the Treasury,” it says, “to provide the necessary stature and other supervisory benefits, provided the Department is given adequate oversight authority.” Regardless of the outcome, we believe that the move to improve oversight of the GSEs will benefit the market for their debt securities.

The Markets
In January, the bond market was volatile but finished the month about where it started. The volatility of the dollar was felt in the gold market, and stocks had a generally good month.