HSBC revises its US forecasts

HSBC were of the opinion that second half growth would disappoint. It appears that as far as the third quarter goes, we were wrong.

There is sufficient evidence now that GDP growth will be stronger than what we were initially looking for, as published in the Q3 edition of Global Economics.

We are changing our Q3 GDP estimate to 4.5% from 2.4%, and we are changing our Q4 forecast from 1.5% to 2.0%. This raises the 2003 year-average GDP forecast from 1.9% to 2.3%.

Partly due to more positive "shadow-effects" from 2003H2, our year-average 2004 GDP forecast has been upgraded slightly to 2.6% from 2.2%, but this is still consistent with our longer-term "stagnation" view.

We continue to believe that core inflation will drop to 1% in 2004, from 1.5% currently.

As a result of these upgrades to H2 growth, we have abandoned our forecast of a 25bp cut in Fed funds in September, postponing the cut to Q1 next year. So we are keeping our 0.75% Fed funds call intact (a view we first adopted in August last year), but it will take a little longer than we anticipated for it to come through.

As a result of the above factors, as well as the huge sell-off in Treasuries over the past two months, our year-end call of 3.0% for 10-year Treasury yields is now untenable.

Nevertheless, we think that a decent rally can still occur, and we now look for 3.9% 10-year yields at year-end, as we expect 2% GDP growth in Q4. We also expect employment to remain weak.

At the very least, this should take out the monetary tightening that the market expects in 2004, where futures markets are suggesting 1.75% Fed funds in July 2004 and 2.25%-2.50% for end-2004. We do not see the first Fed tightening until Q1 2005 at the earliest.

The taking out of the 2004 rate hike expectations should benefit the entire curve over the medium-term.

Why are we raising our Q3 GDP call? Data that feed into both consumer spending and business investment have all surprised to the upside. Specifically, July'sretail sales, together with upward revisions for June, have put consumption on a strong Q3 track.

We are raising our Q3 consumption forecast from 3.3% to 4.5%. Apparently, more of the tax cuts are being spent than what we thought likely, while cash-outs from mortgage refinancing is still high.

Meanwhile, the July durable goods report showed strong gains for non-defense capital goods (ex-aircraft) shipments, which puts business investment on a strong Q3 track, even if August and September were to show declines.

As a result, we have had to significantly raise our business investment forecast from 3.5% to 9.0%. Moreover, June's trade data has resulted in our export forecast being revised up while our import forecast gets revised down, so that net trade now contributes 0.3ppts to growth instead of the 0.6ppt drag we were estimating.

We are concerned about the sustainability of the upswing that we are currently seeing, and that is reflected in our 2% GDP call for Q4.

Specifically, the significant boost to consumption due to cash-outs from mortgage refinancing will tumble in Q4, due to the sharp rise in mortgage rates over the past two months. (It does not hurt Q3 consumption because despite higher rates, it takes banks a few months to clear the backlog of applications that are already in the system.)

This could seriously undermine Q4 growth. It would not be a problem if employment became strong, as the income generated from this source would easily offset the drag from lower cash-outs. However, there is little evidence that the upturn in activity is resulting in higher jobs growth anytime soon.

Indeed,despite the sea of positive economic news, the latest clues on jobs are worrying: August initial claims remain around 400,000; August continuing claims remain near cycle-highs; August Jobs Hard To Get index hits new cycle-high; and August Philly Fed and NY Empire employment
components both plunged.

Our longer-term concerns about the risks in a post-bubble environment, such as excess capacity, excess debt, poor retained earnings and persistent inflation undershoots, remains unchanged.

Some observers have suggested that it is becoming very difficult to justify a negative medium term view on the economy, given the recent data. We
disagree. Yes, there's been a lot of good news, but as a long "not so good" list shows, the economy is not out of the woods just yet.