The Days Ahead:

  • Lighter economic news week so focus will be on 105 company earnings reports.

This Week:

  • The U.S. economy continues to grow fast.
  • China’s economy may never be as big as the U.S.
  • What happens after a rate cut?
  • ASML is helping to build chip plants everywhere, except Europe.
  • The U.S. Treasury will issue fewer bills and bonds than expected.
  • A New York bank goes on a swan dive.

The U.S. Roars Ahead

The economy is roaring right now, with GDP coming in at 2.5% for 2023 and 3.3% annualized for the final quarter of 2023. In nominal GDP terms, which does not account for inflation, the economy grew 6% or $1,600 billion, to $28,000 billion. In the last two years, U.S. GDP is up $3,700 billion or 15%. That’s equivalent to 90% of German GDP.

During peak-China fever from 2010 to 2015, most forecasters thought China would surpass the U.S. between 2020 and 2025. On some measures, notably the use of purchasing power parity (PPP), China is larger than the U.S. and has been since 2014.

We tend to take PPP measure with a grain of salt.

They’re fiendishly difficult to calculate and there’s little agreement on their reliability. The Economist’s Big Mac Index is a version of PPP. It works on the principle that the price of a standardized product like a Big Mac, with staples like bread, beef, labor costs and overhead, should be broadly similar. But it’s not and probably never will be. The Economist recognizes this and also uses a GDP-adjustment index: the richer the country the more expensive the Big Mac. But the results don’t change. Even they treat as a bit of a joke.

The latest Big Mac Index looks like this:

The U.S. is way over on the left. According to this measure, the U.S. dollar is overvalued against all the currencies to its right. Only the Swiss franc, the euro, and the Swedish and Norwegian kroner are more overvalued.

The Argentine peso shows up as overvalued but it’s new government recently devalued the peso by 50% and imposed price controls. The current price is around $1.25, way to the right of Taiwan. PPP relies a lot on currency movements. Hence our skepticism.

But the size of the U.S.’s and China’s economy is worth measuring. Here we use the latest GDP of the U.S. and Chinese economies using a simple value of dollars produced. If they’re the same size the ratio will be 100%. The gap has widened and is back to 2019 levels.  

The trend reversed for two reasons. There was a large fiscal stimulus in the U.S. and quick recovery in employment and wages. In contrast, China kept its economy closed for much longer than other countries and the expected rebound from the 2023 reopening failed to materialize. Now, estimates for when China’s economy may exceed the U.S. range from 2050 to never. The “never” camp says that the currency will depreciate and the working-age population is shrinking too fast.

It could all move quickly in the other direction. A currency move, a burst of growth in China and the gap could narrow. But for now, the U.S. economy is far outrunning China.

What Happens After a Rate Cut

The recent strength of U.S. growth and improvement in inflation means we didn’t see a cut to the Fed funds rate this week. It’s possible for March, April, or May. I know that’s not much of a prediction but the news has been good lately and the Fed is in no rush.

We wanted to see what happens to the 10-year Treasury when cuts start so looked at the cuts from 2000, 2007 and 2019.

The vertical line in the center is the date of the Fed’s first rate cut in each of those years. We then looked at how rates behaved 150 days before and after the cut.

We saw that 10-year Treasury rates started to drift down in the two months before the cut. For the three periods rates fell between 0.4% to 0.8%. After the cut, the drift down continued for another 60 days for a further decline of around 0.15% to 0.40%. After that, there was a brief back-up in rates and then sideways.

What’s the takeaway?

In 2023 and 2024, we’ve seen rates ease by 1.20% and then move back up by 0.20%. It’s an unusual move but in the last few months, we’ve seen big improvements in inflation, continued growth and the Fed telling markets they’re done with hikes. Based on the last three times we’ve seen the Fed cut, we’d expect the market to drift for a while.

If the pattern holds, we’d expect rates to drift down ahead of an expected cut in May. There’s no sign of that right now.

ASML: World’s Leading Supplier to Chip Makers

We mentioned ASML briefly last week. It’s the world’s leader in making the hardware that allows chipmakers, like TSMC, NVIDIA, Samsung, Apple and Intel to make chips. The company only has around 12 customers.

The machines themselves fire balls of tin, measuring 30 millionths of a meter (30 microns), into a vacuum at 70 meters a second (150 mph). The tin is then pulverized by plasmas to turn them into 13.5 nanometer (a billionth of a meter) strips which are then collected on the flattest mirrors ever produced. The mirrors are two feet across. If they measured 3,000 miles, the largest imperfection would be one millimeter.

Four hundred chips are placed on a wafer and each chip can contain up to 100 billion transistors. The plasma light hits them 50,000 times a second 24 hours a day. An iPhone uses about 10 billion chips. The science, to this layman, is baffling and marvelous.

These are sophisticated machines that cost around $150 million apiece and ASML requires its own staff to be on site when the machines are in use…which is 24 hours a day.

The company recently announced sales of $30 billion with net income of $9 billion, up 40% over the year.

All good but one item caught our eye. This map shows the 20 new fabrication projects the company has scheduled for the next two years.

It’s good to see projects in the U.S. which is a direct result of the CHIPS Act in 2022. But there are none in Europe.

None.

It’s not through lack of trying. The EU has around 8% of the world chip market and wants to be at 20% by 2030. It passed its own version of the CHIPS Act last year, promising €15 billion in aid for R&D and production in semi-conductors and chips. That’s not as much as the U.S.’s $52 billion in subsidies but it’s a start.

TSMC and Intel are building plants in the EU. But they’re not at the technological level of the latest chips that ASML can help make. They’re mainly for the appliance and automotive trades.

The outgoing CEO of ASML has warned that the EU cannot meet its goal of 20% share. He may be right. We’ve always known that the high-tech industry in Europe is pretty thin on the ground, with only ASML and Arm as standouts. There may not be much change coming.

Treasury Funding Back in the News

There was a time when the U.S. Treasury’s announcement of quarterly refunding needs was pretty arcane. Here’s what the report looks like:

It looks like a casual spreadsheet but the white ‘Marketable Borrowing” column fourth in from the left holds some very relevant information. It shows the amount of debt the Treasury intends to auction in the current and next quarter.

It takes several steps to get to this number.

First, government departments tell the Treasury how much they need to operate. That gives them a number. Second, the Treasury consults something called the Treasury Borrowing Advisory Committee (TBAC) who tells the Treasury what sorts of bonds, bills, maturities, floating and inflation debt the market wants. Third, the Treasury looks at the amount of cash in the Treasury General Account (TGA). Fourth, comes up with a number for the debt it needs to borrow. The final step is to announce how much of the debt will be in bills (bonds of less than two years maturity) and coupon bonds (everything else).  

Normally this process garners little attention. Not this week. There were two reasons it caught investors’ interest.

First, back in October, the Treasury expected there to be $816 billion net borrowing in Q1 2024. That number is now $760 billion. It’s a big drop and is because the Treasury had more in the TGA than it expected. It’s around $863 billion. Back in October, they thought it would be $750 billion.

At the same time, Treasury’s estimate for Q2 2024 was $202 billion, down from $657 billion in Q2 2023. The drop is because last year’s issuance schedule was thrown into confusion with the debt ceiling and the U.S. Treasury going through hoops to meet its borrowing needs. Also, tax deadlines were delayed. Receipts this year are expected to be up around 45% from last year.

Second, the mix of coupon and bill issuance changed. In the second half of last year, the U.S. Treasury upped the amount borrowed in the bill market (in the blue line below).

As soon as the debt ceiling was agreed in June of 2023, the U.S. issued $1,500 billion in bills in the next six months, talking the share of bills from 15% of total issuance to 21%. That’s close to normal levels for the last 30 years. The upshot is that bill issuance should drop this quarter. Lower bill issuance should mean more coupon issuance, and indeed those numbers went up from last year but were below expectations. For example, February’s issuance of long-term notes and bonds will be almost unchanged from the last few months. Investors were expecting higher.

So, all that means borrowing was less than expected, short-term bill issuance will drop and issuance projections have peaked, alleviating pressure on the Treasury market’s ability to absorb the high levels of debt. Good.

The Bottom Line

The main news of the week was the Fed meeting. There was no surprise to its decision to hold rates but there was a big change in its language. It removed the reference to “any additional policy firming” and replaced instead saying its goals of inflation and employment were “moving into better balance.’ Markets were on the lookout for signs of a March cuts but Chair Powell gave little away saying:

A month ago, the market thought there was a 73% chance of a cut in March. It’s now down to 38%. The expectations for a May cut went from 11% to 60%.

Meanwhile one of the biggest market moves came from New York Community Bank (NYCB), who’s stock did this:

NYCB was once a $23 billion bank but is now worth $4 billion. If the name sounds familiar, it’s because it was the bank brought into rescue Signature Bank in May 2023. Assets doubled in less than a year but net interest margins fell, deposit costs rose and capital requirements went up. The old warning to beware of banks that grow too fast comes to mind.

Markets are understandably skittish when it comes to bank woes. The question is always “is it the bank or is it the system?” A repeat of last May’s bank problems would put stocks into a U-turn. It seems it’s mostly the bank which has a large portfolio of rent controlled multi-family mortgages. The system seems fine. But you never know until you know, and then you know, you know?

The good news for the week was in productivity, which rose 3.2% and the Employment Cost Index, which is probably the only wage indicator the Fed takes seriously, which rose 0.9% for Q3 2023. That’s a good combination and will take further pressure off inflation.

Stocks were mostly up but with three of the Mag 7, Microsoft, Google and Tesla, all showing some weakness. In the case of the first two, that’s probably temporary. European and U.S. stocks are both up around 2.5% year to date. A nice start to the year.

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Art of the Week: Phyllis Shafer (b. 1958)

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