U.S. Trade Deficit Narrowed Sharply in July

The U.S. trade deficit narrowed sharply to -$42.8 billion in July, well above market expectations for a -$47.0 billion shortfall going into the report. June's deficit was revised only modestly to -$49.8 billion from the initially reported -$49.9 billion. The improvement in the trade balance in the month reflected a sharp $4.2 billion (-2.1%) drop in imports paired with a $2.8 billion (1.8%) rise in exports.

The improvement in the trade balance in July was led by a surprisingly large 2.1% drop in imports along with a 1.8% rise in exports. While the drop in imports is somewhat disappointing, it only partially retraces solid 3.1% and 2.9% increases in June and May, respectively. As well, the trade deficit with China narrowed for the first time in five months, which is consistent with earlier reports that imports from that country were likely pulled forward into earlier months ahead of the expiration of export incentives in the middle of July. On an industry basis, the drop in imports was widespread across industry categories. The 1.8% increase in exports reflected solid growth in capital goods and “other merchandise” exports that was offset only partially by falling exports of automotive vehicles and parts. On a volumes basis, exports rose 2.9% while imports dropped by 2.2% resulting in the real goods deficit narrowing sharply to -$47.7 billion in the month from -$53.6 billion in June.

The narrowing of the real goods deficit in July suggests that net exports will likely act as much less of a drag on GDP growth (potentially even acting as a support) in the third quarter than the sizeable 3.4 percentage point subtraction recorded in the second quarter. While this suggests some upside risk to our current growth forecast, the drop in imports in July could be reflected in less of an add from inventories. This, along with an expected slowing in domestic demand will likely limit the improvement in overall GDP growth to a 2.0% annualized increase from the 1.6% gain recorded in the second quarter. This would be still well-below the 3.7% and 5.0% increases recorded in the first quarter of this year and the fourth quarter of last year respectively. While the pace of growth has moderated more in the middle of 2010 than was previously expected, we do not expect the recovery to falter. With that said, the pace of improvement going forward will likely be sufficient to put only modest downward pressure on the unemployment rate in the near term. This along with a still subdued outlook for inflation suggests little reason for the Fed to begin raising rates soon. We do not expect an increase in the Fed funds target from its current 0% to 0.25% range until the third quarter of 2011.

In a separate report released this morning, initial unemployment insurance claims dropped an encouraging 27,000 to 451,000 for the week ending September 4, 2010. From the previous week's 478,000 level (initially reported as 472,000). The level of claims has now dropped by 53,000 in the past three weeks following the surprising run up to a 504,000 level in mid-August. Expectations were for the level of claims to fall to 470,000. The four-week moving average of initial claims, which normally provides a better indication of the underlying trend in labor markets, slid to 477,750 from 487,000 the prior week.