In today’s video we dissect the 2nd quarter GDP results and what it means for the US recovery. The economy grew a smaller than expected 2.4% annualized rate. We also cover the important releases to look out for next week.

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The unemployment rate for June unexpectedly rose to 5.3% from 5.2%. That is a seven-month high for the jobless rate. A second report showed that factory output – industrial production – was down 1.5% for the month. Economists had expected a small gain. Consumer prices continued to show negative annual rates. For the country the consumer price index excluding food declined 1% from a year before.

In one positive report household spending did rise 0.5% in June compared to a year ago, following a 0.7% year-over-year decline in May. Expectations had a drop of 0.9% y/y figure. That means consumers were more willing to spend, but if the economy weakens then consumers may cut back spending again.

Japan’s economy is expected to show growth slowing to an annual rate of 1.9% in the 2nd quarter, following a sharp 5% rise in the 1st quarter.

The data will increase worries about a slowdown and put pressure on the government for solutions. Recently the Prime Minister has talked more about consolidating Japan’s fiscal deficit than stimulative economic growth. There will be increased pressure on the Bank of Japan as well, perhaps in the form of proposals to buy long-term governmetn bonds and target infaltion of 2 to 3 percent.

Breakdown of Today’s Report

Expectations had been for a 2.5-2.6% annualized rate, but the economy grew 2.4%. In the 1st quarter there was  strong upward revision showing the economy grew 3.7% – the final version for 1st quarter growth had this figure at 2.7%. The growth in the 1st quarter was driven primarily by a rebuilding of inventories.

Consumer spending, the key engine of the US economy as it makes up about two-thirds of GDP, rose by a moderate annualized rate of 1.6%, compared to 1.9% for the 1st quarter. With an unemployment rate at 9.5% it makes sense that this figure is weak right now.

Now, business spending on equipment and software continued its strong pace from the 1st quarter when it jumped 20.4%. In the second quarter, business investment was up 21.9%. Again, this highlights the contrast in the economy between high company profits and a persistently feeble jobs market which is keeping consumers at bay.

The trade gap also weighed on growth as the trade deficit widened to $425.9 billion in the 2nd quarter from $338.4 billion in the first. That subtracted 2.8 percentage points from growth. Imports were up 29%, while exports rose 10%.

Implication for Recovery and Fed

Last week, Fed Chairman Bernanke said that the economy’s outlook was “unusually uncertain”, and has stressed that it would be consumer and business spending that would have to take the reigns as government stimulus efforts fade. Also, central bank officials have already reiterated they plan to keep rates at near zero for an extended period, so unless there are some new programs that come out from the August 10th meeting of the FOMC, it’s unclear what the Fed can do at this point.

There is a growing concern that some type of support is necessary, as the threat of deflation is becoming more serious. Price data today showed the core personal consumption expenditure – a rate of underlying inflation which excludes food and energy prices and is closely watched by the Fed – increased by 1.1% from the previous quarter. That was the weakest since the 1st quarter of 2009 and lower than the 1.2% seen in the 1st quarter of 2010. In other words price pressures are heading in the opposite direction that policy makers would like.

Revisions

In the first quarter, the economy grew by 3.7%, revised up from an originally reported 2.7% increase, but as we mentioned the increase there was led by inventories. But, while 1st quarter growth was revised higher, growth estimates all the way back to the start of 2007 were revised lower. For instance the 4th quarter of 2009 saw growth of 5.0%, not 5.6%.

For all of 2009, the government said the U.S. economy contracted by 2.6%, compared to the previously estimated 2.4% decline. In the whole of 2008, GDP was flat, instead of rising 0.4% as previously estimated. In 2007, the world’s largest economy expanded by 1.9%, down from an originally reported 2.1% increase.

Can’t blame the big fall on the transportation sector, as orders excluding transportation were down 0.6% as well. Within the transportation sector orders for airplanes fell while demand for cars and motor parts increased (2.5%). As durable goods are those designed to last more than 3 years its a sign that the manufacturing sector is cooling, and most of the decline was focused in industrial sectors such as electronics (-1.9%), machinery (-0.7%), and metals (-2.0%). Manufacturing as we should remember has been at the driver seat of the recovery and its slowdown is a bad sign. On a positive note, there was a pretty big increase in orders for computers (+2.5).

Still, there is one takeaway from this data, and that was a barometer of capital spending by business rose. Orders for non-defense capital goods excluding aircraft increased by 0.6%, after rising 4.6% in May. Expectations had been for a flat reading. That could mean that companies see the economy recovering in a way that they need to upgrade their capital infrastructure.

Overall, like I said at at the top of the story, this data will add to other data showing that the manufacturing is slowing following a strong rebound earlier in the year. With consumer confidence falling – and the propsect of weaker spending that comes with it – there is going be a challange on how to get the US economy moving again.

A strong UK sales release and upbeat results about Euro-zone lending and money supply led a move in higher yielders and boosted “risk-on” trades. But, a weak US consumer confidence report took some of the momentum out of risk seeking behavior and caused the greenback to recoup some of its earlier losses.

Still, it was the second monthly increase in prices as the 10-city index rose 1.2% compared with April, and the 20-city index rose 1.3%. Adjusted for seasonal factors, both increased 0.5%. From a year earlier, the 10-city index rose 5.4%, and the 20-city reading climbed 4.6%. That was better than forecasts and should help the risk appetite momentum that has taken hold in equities and currency markets in the first half of this week.

Prior to April, the S&P index had declined for 6 straight months on a monthly basis. What the readings suggest then is that since reaching its recent trough in April 2009, the housing market has really only stabilized at this lower level.

This chart shows the index levels for the 10-city and 20-city composite indexes. As of May 2010, average home prices across the United States are back to the levels where they were in the autumn of 2003. Measured from June/July 2006 through May 2010, the peak-to-date figures for the 10-City
Composite and 20-City Composite are -29.6% and -29.1%, respectively.

The rest of the week is full of releases as well, with new home sales released today, the Case-Schiller house prices and consumer confidence on Tuesday, durable goods and the Fed’s Beige Book on Wednesday. The week ends with second-quarter GDP, Chicago Purchasing Managers Index and final University of Michigan-Reuters consumer confidence on Friday.

The releases this week will be closely watched following Fed Chairman Bernanke’s remarks last week that the U.S. economy is heading for a period of “unusual uncertainty.” His comments, before Congress, follow a string of disappointing economic indicators.

Things We Should Learn by the End of this Week

In addition to the first look at GDP figures which should show an economy growing slightly slower than what as we saw in the 2^nd quarter, a couple of key points we should look out for. One is consumer confidence. We know that with government stimulus waning monetary policy makers and government officials would like to see consumer and business spending take the baton from loose monetary policy/government stimulus. We have had two months of weak retail sales and firms were reluctant to hire the past several months as the sovereign debt crisis in the Euro-zone intensified.

With a retrenching housing market & construction sector because of the end of the government’s home tax credit, that added housing to employment and consumer spending/confidence as weak readings recently. We also saw the pace of manufacturing activity slow in June.

Overall, that has put the US economy in the cross hairs, especially as we’ve seen some pick up in Euro-zone of late – strong manufacturing and services PMI, industrial new orders, and German business confidence. With the fear of sovereign debt and the concerns of the solvency of the European banking sector fading, the contrast has been rather sharp between Europe and US of late.

Also, in the UK we saw a very surprising 2^nd quarter GDP report which has further underscored the weak data from the US. With emerging economies doing well and raising rates on fear of inflation (think India) and Chinese officials trying to cool their overheating economy, the US looks like an island of weakness right now and that has been reflected by weakness in the greenback, first in early June, but again throughout July.

US Releases this Week

This week’s data than could be a turning point.

Tuesday – Consumer Confidence & Housing Prices

While we don’t have consumer spending figures this week, we do have consumer confidence on Tuesday. Now, it’s not a guarantee that sentiment translates to weaker or stronger spending, but it does have a close correlation to the labor market. If its harder to get jobs, we tend to see weaker confidence, however if the job market is tightening than confidence tends to go up.Currently, the forecast is for a slide in the Conference Board consumer confidence index to 51.3 in July.

So, have firms gotten over the uncertainty due to Europe in May/June? We don’t have employment data either this week, except for weekly jobless claims so we have to wait for the first week of July for that. But we do have some figures that can help paint us a picture of domestic demand on Wednesday in the from of durable goods orders.

Also, the housing sector has been very beat up as of late, but prices have been rising from their levels one year ago. We get the latest data on prices from the S&P/Case-Shiller 20-city house price index. Expectations are for prices to be 3.9% higher in May compared to a year ago.

Wed – Durable Goods and Beige Book

Durable goods orders are one of those indicators that rise , in that those are the goods that consumers and businesses purchase when they are feeling more confident as they are good designed to last 3 years or more. The expectations is that durable goods will be up 0.9% in June, following a 0.6% decline in May.

The Beige Book is a good measure of the overall economy, as it assesses how the Fed sees things shaping up. It gives important anecdotal information on current economic conditions, bringing together various data on various industries broken down by regions. While it’s not necessary to read through the whole report it will give us a clear idea of what policy makers are reading. Will it show an economy that is weakening, or one that had hit a rough patch in the wake of the Euro-zone sovereign debt crisis and may now get back to recovery? How is lending and borrowing conditions?

Therefore Wednesday’s look at durable goods and the Beige Book will be a nice appetizer for the 2^nd quarter GDP report.

Fri- GDP and Chicago and Chicago Fed

The economic slowdown in the US will be evident in Friday’s GDP release. The first look at the second quarter should show the U.S. economy grew at an annual rate of 2.5%, from a 2.7% pace in the first quarter.

The mix of growth will be important in setting the tone for the second half. For instance, if the inventory sector contributed significantly to second-quarter growth, stock rebuilding could be a drag in 2010’s latter two quarters. On the other hand, if consumer spending grew by less than personal income did, a bounceback could occur this quarter.

For an early look into the third-quarter manufacturing sector, investors and economists will have July factory reports from regional Federal Reserve banks in Dallas, Kansas City and Richmond and from the Institute for Supply Management in Chicago due out Friday. The Chicago PMI is a good leading indicators for the ISM manufacturing and services PMI’s and is expected to weaken to 56.1 from 59.1. Still, a level above 50 indicates expanding activity. The Richmond Fed, which comes out earlier in the week is also expected to decrease.

The day’s big event was the release of Euro-zone bank stress tests, which were set out to gauge whether Europe’s banking sector has sufficient capital, if the economy suffered another more severe shocks than the financial crisis. The results showed 7 banks needed more capital, but questions remain about if the criteria used was too lenient.

A result in which all banks passed would be seen as too lenient and would not go far enough to restores confidence in the Euro-zone financial system. However, if too many banks failed the criteria it could spook investors as they see the Euro-zone banking sector still mired in the sovereign debt crisis.

Well, after much speculation we finally have the results.

As expected the German bank Hypo Real Estate failed. All French, Portuguese, Swedish and Irish banks passed.

In Spain we had several banks failing including Diada Savings, Espigna Savings Bank Group, UNNIM Group, Banca Civica and CajaSur. Now Spain has moved already to consolidate its banking sector and has set up funds to facilitate that process. Spanish banks were particularly hard hit by the crisis as a large housing bubble left Spanish financial institutions with many bad loans on their books.

Finally, one Greek bank ATE Bank also failed the requirements.

In all the failed banks will need to raise a total of 3.5 billion Euros. Failure of the test meant that under the adverse conditions laid out after a sovereign shock, banks would see their Tier 1 capital ratios fall below 6%, a threshold that is above the regulatory minimum of 4% Tier 1 capital.

Earlier in the session the Euro floundered as details of the tests methodology became known. It led some investors and traders to question whether the tests were stringent enough. While the test scenario assumes a double-dip recession, a 20% decline in equity markets and a sharp rise in interest rates, the main drawbacks being that the tests would not treat the impact of sovereign debt losses on trading books and bank books equally.

While default was not an option in the stress tests, the tests did assume a haircut, or discount, of 23.1% on Greek bonds at the end of 2011, reports said. The haircut on Portuguese bonds is set at 14%; Spanish bonds, 12.3%; and German bonds, 4.7%, reports said.

Second, bank-book assets would not be marked down in the same way as trading-book assets because they are assumed to be held until maturity, whereas trading-book assets have to be marked as their prices fluctuate and losses are reflected in banks’ quarterly earnings. But, bad bond purchases could have been stuffed into the bank’s portfolio while profitable trades were left as trading-book assets.

Following the results, we had some choppy trading, which is not unusual in the immediate aftermath of major news or data, as initial movements often reflect positioning and knee-jerk reactions which investors may cast aside once they’ve had time to sift through the details of the report.

By 1 PM EDT time, the EUR/USD was trading near its low for the day, as banks that were suspect passed the tests, meaning the credibility of the tests may pressure the value of the Euro. A high-profile failure or two and several tens of billions of capital needs would have been greeted as more realistic from the market.

The euro and others gained sharply against the dollar Thursday after better-than-expected euro-zone and U.S. economic data boosted investor sentiment toward riskier assets. US equities were higher as US companies releases some strong earnings, which only further propelled currencies like the Aussie and Loonie.