What happened to the old twin deficits (budget & trade)? Econoday Simply Economics 9/22/00 By Evelina M. Tainer, Chief Economist

Strong dollar, rising oil depress equities
Reports that third quarter earnings may be weaker than expected led to a trimming of second-half profit estimates and a sour week in the stock market. The news wasn't any different than last week. For the most part, investors worried that oil prices would hit $40 per barrel and that the weak euro/strong dollar would depress corporate earnings. Last week, the bulk of the weakness came in the NASDAQ composite index. This week, the Dow Jones Industrials, the S&P 500 and the Russell 2000 all took a hit. As a result, the Wilshire 5000 (which comprises the entire market) also fell.

It didn't help that three major central banks (ECB, BoJ, and the Federal Reserve under the authority of the U.S. Treasury) intervened in favor of the euro on Friday morning as everyone sold dollars and bought euros. The euro was rising in early U.S. trading and the European Central Bank took advantage of the rising trend to intervene. (Trying to intervene in a rapidly declining market isn't recommended as the tide is going against you. But if the market is starting to rise, the extra push helps the currency move forward.) After the morning's currency intervention, U.S. stock prices opened sharply lower - and apart from the Dow Jones Industrials, maintained the lower levels throughout the day.

Rising oil prices lift Treasury yields
Bond investors are beginning to worry about oil prices again. For a while, oil prices didn't raise alarms as market players didn't expect inflationary pressures to result for general consumer goods. Unfortunately, the increased production schedules set by OPEC recently are not having much impact on reducing crude oil futures prices in the near term. Several analysts have mentioned $40 per barrel as a good possibility in the near future. But in a move that may at least push back that possibility, the White House said late Friday it is opening up its strategic reserves and will take bids beginning Monday for 30 million barrels of new supply.

Higher crude oil prices will not only lead to higher gas pump prices (which are already being felt), but also to higher fuel oil prices as winter approaches. It is worth considering that higher oil costs may have less of an inflationary effect on general prices and more of a dampening effect on consumer spending. If consumers are spending more on fuel, they have less discretionary funds for retail sales. If bond investors see that the core CPI is not impacted in the next few months, it is likely that yields will drift back down.

Markets at a Glance
Treasury Securities	12/31/99	2000 High	2000 Low	15-Sep	22-Sep	Week % Change
30-year Bond	6.48%	6.75%	5.66%	5.90%	5.91%	0.01%
10-year Note	6.43%	6.77%	5.68%	5.83%	5.84%	0.01%
5-year Note	6.34%	6.81%	5.90%	5.91%	5.92%	0.01%
2-year Note	6.24%	6.90%	6.07%	6.05%	6.06%	0.01%
Fed Funds Rate Target	5.50%	6.50%	5.50%	6.50%	6.50%	0.00%
Stock Prices
DJIA	11497	11723	9811	10927	10847	-0.7%
S&P 500	1469	1524	1348	1466	1449	-1.2%
NASDAQ Composite	4069	5049	3164	3835	3804	-0.8%
Russell 2000	505	606	457	531	519	-2.3%
Wilshire 5000	13813	14751	12475	13813	13678	-1.0%
Exchange Rates
Euro/$	1.0008	0.8490	1.0336	0.8540	0.8786	2.9%
Yen/$	102.40	111.35	101.45	107.35	107.84	0.5%
Commodity Prices
Crude Oil ($/barrel)	$25.60	$37.20	$21.20	$36.00	$32.65	-9.3%
Gold ($/ounce)	$289.60	$326.00	$273.90	$275.90	$275.20	-0.3%

In the good old days of the 1980s, conventional wisdom was that the large federal budget deficits went hand in hand with international trade deficits. After all, both were symptomatic of excessive spending on the part of American consumers and government policymakers. Analysts claimed that a return to prudent fiscal spending would also lead to smaller trade deficits. The idea was that fiscal policy was overly accommodative. If only fiscal policy were tightened and consumers had less money to spend, it was going to reduce the demand for imported goods and services.

Fast forward to the late 1990s and year 2000. The link between the federal budget balance and the international trade deficit is long gone. The federal budget has shown a surplus these past couple of years even as international trade deficits have widened.

Federal budget deficit turns to surplus
The U.S. Treasury announced a federal budget deficit of $10.4 billion for the month of August after posting a surplus of $5.1 billion in July. This compares with a slightly smaller deficit for the same month last year. Yet, the chart below shows a dramatic improvement in the year-to-date surplus. With only one month remaining in this fiscal year, the budget surplus stands at $170.8 billion. This is nearly three times as large as the budget surplus for fiscal year 1999 when the surplus was $66.3 billion. The total fiscal year surplus for 1999 was 123.6 billion since September tends to be a large surplus month (coming from estimated tax receipts). If the September surplus amounts to the same as last year at $57 billion, it would put the fiscal year 2000 surplus at $228 billion!

So what is causing the budget surplus these days? It is really a combination of extraordinary gains in tax receipts coupled with moderate increases on outlays. Individual income tax receipts are up 13.9 percent in fiscal year 2000 over 1999 (for the 11 months to-date). Corporate income tax receipts are up 13.4 percent over last year for the same period. Even custom duties are 8.9 percent higher than a year ago.

At the same time, increases in government expenditures are more moderate. One of the larger items - defense outlays - are 6.2 percent higher than a year ago. Medicare expenditures are 4.1 percent higher than last year while social security payments are up 4.8 percent versus a year ago.

Net interest payments are down 2.2 percent relative to a year ago. Remember that a large government debt creates the need for higher and higher debt service payments. Now that the federal debt is not increasing as rapidly - and actually decreasing slightly - it means that the interest payments will be getting smaller rather than larger.

Incidentally, the net interest costs reflect on the distribution of U.S. Treasury debt in the form of Treasury securities. Now that interest rates have declined in the past 10 years relative to 15 or 20 years ago, the federal government is able to borrow at lower yields which translates into lower costs and feeds into the reduced outlays.

The bottom-line on the federal budget? All the news on the federal budget has been favorable these past couple of years created by a boom in the stock market which has led to realized capital gains and plenty of tax receipts coming from both consumers and corporations. That has led to the current Treasury policy of buying back old 30-year bonds at high yields and also reducing the quantity of new Treasury issues. In the bond market, this has led to significantly lower yields on Treasury securities in the past few years, particularly in 2000. It also has led to slightly higher spreads between Treasury securities and other corporate or agency issues as markets take a bit of time in adjusting to lower yields on these government benchmarks at the same time that the Federal Reserve is tightening credit conditions.

Government policymakers in the administration and Congress have taken advantage of this good fortune of economic prosperity fed by individual and business tax receipts. Every one seems to be forecasting large budget surpluses as far as the eye can see (about 10 years out). Consequently, some lawmakers are proposing tax relief while the Administration adheres to paying down the debt. It will be interesting to see if the budget surpluses actually do hold for several years - even if tax receipts moderate in the coming years as economic activity slows down. Indeed, even if the stock market just treads water over the next several months, fewer investors will be realizing capital gains. If a few realize losses instead, it will mean a smaller tax bite.

Trade deficit widens
The international trade deficit on goods and services widened in July to $31.9 billion after averaging $29.8 billion in the previous two months. Exports fell 1.5 percent in July after gaining 4.8 percent in June. Imports edged up 0.6 percent in July after rising 3.6 percent in the previous month. Basically, a drop in aircraft shipments hampered exports; gains in other sectors were not large enough to take up the slack. On the import side, gains in industrial supplies and autos & parts led the gain. Other sectors were stable.

While the trade deficit continues to climb, notice in the chart above that the yearly rise in imports has dropped several percentage points over the past six months. Some of the upward drift earlier this year was due to increasing oil imports from accelerating crude oil prices. Oil prices had abated for awhile but appear to be coming back. That means that the oil import bill could accelerate again in the next few months. In July, the yearly rise in exports moderated slightly, but the trend was clearly upward through the first half of the year.

The interesting question is what will happen to exports in coming months. Foreign exchange rates have some impact on demand for foreign goods and services. The foreign exchange value of the euro has deteriorated sharply (versus the U.S. dollar) since it was first instituted in 1999. A weaker euro means that European goods are cheaper for U.S. residents, but also means that U.S. goods are more expensive for Europeans. In the past year, our bilateral trade deficit with Europe has widened considerably. In the first seven months of 2000, the deficit amounted to $34.9 billion, up $10 billion for the comparable 1999 period. That is a 40 percent hike in the deficit!

The U.S. deficit has not increased this much with other key regions. For instance, the deficit with Pacific Rim countries increased 16.7 percent in the seven months of this year relative to last year and now stands at $116.6 billion for the January to July 2000 period. Our trade deficit with Mexico, a key U.S. trading partner is actually stable - amounting to $14.1 billion this year relative to $14.3 billion last year. However, the U.S. trade deficit with Canada has ballooned to $27.0 billion in 2000 from $16.6 billion in 1999. The Canadian dollar is relatively weak versus the U.S. dollar and it has favored Canadian imports at the expense of U.S. exports.

The bottom-line on international trade? The widening of the international trade deficit in July will dampen economic growth in the third quarter. Market players and government policymakers might view this in a favorable light. Bilateral trade deficits often have political overtones that might be negative. For instance, our trade deficit with Japan and China is generally viewed as negative because these markets are not generally open to U.S. exports. Our deficit with Western Europe or Canada & Mexico is tied to economic prosperity and foreign exchange values. As a result, the political aspect is not an issue here. In general, we may see further deterioration of the international trade deficit in coming months as higher oil prices boost the oil bill.

THE BOTTOM LINE
This week's set of economic news didn't give market players, economists, or Fed policymakers any new information on the state of economic conditions. Indeed, the minor indicators that were reported took a back seat to the news about oil prices and the weakening foreign exchange value of the euro.

Looking Ahead: Week of September 25 to September 29
Market News International compiles this market consensus that surveys 15 - 20 economists each week.

Monday
Economists are predicting existing home sales will jump 4.4 percent in August to a 5.0 million-unit rate. This follows a sharp 9.8 percent drop in July. Also, mortgage rates have fallen below the psychological 8 percent rate, which tends to spur buyers. (Forecast range: 4.75 million to 5.10 million unit rate)

Tuesday
The market consensus shows that the Conference Board's consumer confidence index will edge up to 141.5 in September from a level of 141.1 in August. Overall, consumers remain generally optimistic about conditions. (Forecast range: 139.0 to 143.4)

Wednesday
New orders for durable goods are expected to rise 2.8 percent in August after plunging 12.4 percent in July. This reflects some recovery in the volatile transportation component and stable orders in the core components. (Forecast range: 1.2 percent to 8.0 percent)

Thursday
Market participants are expecting new jobless claims to increase 4,000 in the week ended September 23 from last week's 308,000 level. (Forecast range: -5,000 to +12,000)

Economists are predicting virtually no change to second quarter real GDP growth. The Commerce Department's preliminary estimate showed a 5.3 percent rate for the period. Similarly, the chain weight price deflator is expected to remain unchanged at a 2.6 percent rate and real final sales growth at a 3.5 percent rate.

Friday
The consensus shows that personal income should record a 0.3 percent hike in August, matching the July gain. (Forecast range: 0.2 percent to 0.4 percent) Personal consumption expenditures are expected to rise 0.5 percent in August, after gaining 0.6 percent in July. This incorporates the retail sales figures reported earlier this month. (Forecast range: 0.3 percent to 0.6 percent)

Economists are predicting the Chicago purchasing managers' index will edge up to 48 in September from a level of 46.5 in August. Any level below 50 percent means that the manufacturing sector is contracting. (Forecast range: 40.0 to 49.5)

Looking Further Ahead to October
Preliminary estimates show economists are looking for a 220,000 gain in nonfarm payroll employment. We still are seeing declines in temporary Census workers. Excluding Census, the consensus shows a 290,000 rise in payrolls. The unemployment rate should remain unchanged at 4.1 percent in September.