NEWS / Foreign Exchange

Surprise, Surprise, Surprise!

U.S. Review

Surprise, Surprise, Surprise!

This week brought a boatload of positive economic news and threw a bucket of cold water on all those soothsayers calling for recession. Real GDP grew at a 3.9 percent annual rate during the third quarter and the fourth quarter got off to an exceptionally strong start, with nonfarm payrolls adding 166,000 net new jobs. Even the inflation data were milder than expected.

To be certain, the problems in residential construction and structured finance have not gone away. New data on home prices show the ongoing correction in the housing market remains in full swing, particularly in overbuilt markets such as Florida, Arizona and California. Foreclosures also continue to increase and doubtsremain as to whether or not some large lenders have sufficiently gotten ahead of the problem.

This week??™s stronger data reinforce our belief that the problems in residential construction pose less of a risk to the overall economy. While we are not particularly huge fans of pulling the data apart, economic growth excluding residential construction grew at a 5 percent pace in the fourth quarter.

Shazam!

While there are a few other choice words that could describe this morning??™s much stronger than expected employment report, Gomer Pyle probably has the best one. The consensus forecast had called for an increase of around 85,000 nonfarm jobs, which is about half the currently reported 166,000 job gain. Strength was broad based, with gains across most of the service sector. The unemployment rate was unchanged at 4.7 percent, as both civilian employment and the labor force declined during the month.

The weakness in housing is clearly evident in the employment and the GDP data. Employment in residential construction and specialty trades fell by 21,500 jobs in October. Job losses were also evident in manufacturing industries tied to homebuilding, including wood products and furniture. Mortgage banks also continue to shed jobs as do home improvement centers, which cut 7,100 jobs in October. In terms of real GDP, residential construction plunged at a 20 percent annual rate during the third quarter, slicing $26.8 billion, and 1.1 percentage points, off real GDP growth.

While losses from the housing correction are highly visible, the offsetting gains in other parts of the economy have received much less attention. Exports surged at a 16.1 percent pace during the quarter, adding $57 billion to real GDP, or nearly twice the drop in residential construction. Output in business fixed investment and commercial construction also increased. Gains in these areas are creating jobs in other parts of the economy, which are more than offsetting losses in homebuilding and mortgage finance.

The Federal Reserve cut the federal funds rate by a quarter percentage point as expected. The statement that accompanied the Fed??™s decision was a bit more hawkish than expected, however, indicating that the Fed now believes the upside risks to inflation roughly balance the downside risks to growth. The market??™s interpretation of this statement is that the Fed is now on hold and that the financial institutions are now on their own in dealing with the ongoing troubles in the credit markets.

We believe this interpretation is a bit cynical. The Fed??™s concern has always been in the right place, minimizing the downside risks to the economy and financial system, not bailing out investors or financial institutions. Our interpretation of the Fed??™s statement is that they are done cutting interest rates in anticipation of slower growth. Any future rate cuts will likely require a more serious risk to the overall economy, or actual evidence that problems in the credit markets are creating an undue burden on the rest of the economy.

Global Review

As shown in the chart at the left, the Mexican peso has strengthened recently, rising to its highest value against the U.S. dollar since early 2006. Part of the appreciation of the peso reflects the Fed??™s 25 basis point rate cut on Wednesday that caused the greenback to weaken versus most currencies. However, there is an important Mexico-specific factor at play as well. Namely, the Bank of Mexico surprised investors by hiking rates by 25 basis points last Friday, the second time it has tightened policy this year.

Why did the Mexican central bank hike rates? The answer is: Inflation has been running at a higher rate than the Bank expected. As shown in the top chart on page 4, the year-over-year rate of CPI inflation was 3.8 percent in September, well above the 3 percent rate that the Bank had hoped to achieve by the end of 2008. The central bank acknowledged that its 3 percent inflation target was not likely to be achieved until the end of 2009. Inflation has remained stubbornly around 4 percent over the past year, so the Bank??™s acknowledgement that the 3 percent target will not be reached for another year does not seem unreasonable. Indeed, we have been projecting for some time that CPI inflation would not near 3 percent until the end of 2009.

Part of the reason for inflation??™s stickiness this year is that economic activity remains generally solid. As shown in the middle chart, growth slowed in the second half of last year, but it has strengthened again this year. Although the monthly indicator of economic activity does not have perfect correlation with quarterly GDP data, the former suggests that overall GDP growth likely was rather strong in the third quarter. (Official GDP data for the third quarter will not be released until mid-November.) Even if the monthly indicator in September gives back all of the 0.4 percent gain that it registered in August, real GDP in the third quarter looks to have risen at an annualized rate of nearly 6 percent. Both retail sales and industrial have strengthened this year, which lends credence to the notion that growth in the third quarter was rather strong.

That said, we do not expect Mexican growth to remain as strong over the next few quarters as it was in the third quarter. As shown in the bottom chart, the Mexican trade deficit, which narrowed over 2006, is starting to widen again. Some of the widening is due to the pickup in domestic demand, which is drawing in imports. However, export growth has also slowed markedly. Indeed, growth in real exports, which was clipping along at a double digit pace last year, slowed to only 3.6 percent (year-over-year) in the second quarter of 2007. One needs look no further than the slowdown underway in Mexico??™s northern neighbor to understand why export growth south of the border has slowed recently.

Although we project that Mexican growth will downshift a bit in the quarters ahead, we expect the Mexican peso will continue to grind higher versus the greenback. However, our forecast is more a reflection of generalized dollar depreciation than it is of peso strength, per se. As we explain in our ???Monthly Economic Outlook???, which is posted at www.wachovia.com/economics, the combination of a large U.S. current account deficit and narrowing