Equities briefly stumble while the Fed stays on hold
By R. Mark Rogers, Senior Economist, Econoday
May 11, 2007

Last week saw an end to the Dow’s record bull run on Tuesday and heavy profit taking on Thursday. Nonetheless, equities quickly rebounded on Friday on positive inflation news and continued good earnings. Meanwhile, the Fed continued to fret over inflation, leaving the fed funds target rate unchanged at the latest FOMC meeting.

Recap of US Markets

OIL PRICES

Oil prices continue to play a key role in equities, bonds, and in inflation numbers. However, last week, oil prices ended up only marginally despite much of the usual daily volatility. Prices slipped on Monday as traders began to anticipate higher distillate stocks for the week. But on Tuesday, traders reversed, thinking that any increase in stocks would be modest while demand is still quite strong. Concern over militant activities in Nigeria also boosted prices. Still, on Wednesday, stocks were reported higher than expected, driving crude down by almost a buck and a quarter. Prices drifted back up on Thursday and Friday, largely reflecting a shift in market focus on continued healthy demand and uncertainty over Nigerian oil flows.

The spot price per barrel for West Texas Intermediate edged up for the week by $0.44 per barrel to close at $62.37 per barrel.

STOCKS

Equities were mixed last week with the Dow industrials managing to pull off a modest gain while other major indexes declined. Monday was led by the blue chips – primarily boosted by Alcoa’s hostile bid to buy competitor Alcan. Techs dipped as Yahoo! slipped from Friday’s gains tied to merger speculation with Microsoft. The Dow ended its bull run on Tuesday with a dip of about 4 points. As of Tuesday, the Dow had risen in 24 of 27 consecutive sessions – tying an almost 80-year-old record. Techs edged up, closer to a six-year high. Wednesday saw a resumption of equity gains, with the Dow and small caps leading the way. Basically, during the last 90 minutes of trading, market psychology turned to relief that the Fed FOMC statement had no new news – especially in terms of not having any worsening in inflation fears. Lower oil prices also supported equities. The S&P 500 ended the day just shy of its all-time high while the Nasdaq topped a six-year high. Equities fell sharply on Thursday due to lackluster chain-store sales stirring up concern over the strength of the economy, higher oil prices, and rethinking that the Fed made no movement toward removing its anti-inflation bias in the FOMC statement. Heavy profit taking also set in. Also pulling down the Dow was a drop in Johnson & Johnson due to an adverse recommendation by a government panel to restrict the use of anemia drugs in cancer patients. J&J fell 2 percent. Equities rebounded Friday as investors interpreted the flat core PPI for April and weak retail sales as improving odds for Fed rate cuts later this year. Honeywell, Caterpillar, and IBM were notably strong, boosting the Dow.

Last week, the Dow was up 0.5 percent. Other major indexes were flat or down. The S&P 500 ended the week a hair above flat. The Nasdaq and Russell 2000 both were down 0.4 percent.

Year-to-date, the Dow is up 6.9 percent; the S&P 500, up 6.2 percent; the Nasdaq, up 6.1 percent; and the Russell 2000 is up 5.3 percent.

BONDS

The yield curve was up slightly for the week except on the near end. Starting the week, rates eased marginally on Monday, largely due to slippage in oil prices. On Tuesday rates were little changed, with investors on the sidelines, waiting for Wednesday’s FOMC statement. On Wednesday, with no movement in the FOMC statement toward removing the Fed’s anti-inflation bias, bond traders took a more negative reading of the minutes than did equity traders and Treasury rates rose, ranging 3 to 6 basis points for the day. Bonds were little changed on Thursday and Friday. Jobless claims came in lower than expected Thursday morning while chain-store sales were weaker than expected later in the day. Friday’s favorable core PPI had little impact on rates except on the T-bill which eased somewhat. Later in the day, rates generally rose due to flow of capital from bonds into equities. Also, news of pending possible terrorist attacks on Americans in Germany nudged rates up.

Net for the week the Treasury yield curve is up modestly except for the 3-month T-bill. Yields were up as follows: 2-year T-note, up 4 basis points; 3-year, up 3 basis points; 5-year, up 3 basis points; the 10-year bond, up 4 basis points; and the 30-year bond, up 4 basis points. The 3-month T-bill was down 3 basis points.

The 3-month T-bill continues to trend downward while other rates continue to trade in a narrow range as has been the case over the last few weeks.

Markets at a Glance

Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.

The Economy

The focal point of the week was the Fed’s May 9 FOMC policy meeting which left rates unchanged and the statement bias unchanged. Later in the week, producer prices were mixed and retail sales came in on the soft side.

The FOMC keeps rates unchanged, still focusing on inflation remaining too high

Once again and as was very much expected, the Fed left interest rates unchanged at its policy meeting. Importantly, the Fed continues to focus on the possibility of inflation remaining too high. At the May 9 FOMC meeting, the Federal Open Market Committee kept the target for the federal funds rate unchanged at 5-1/4 percent and retained its anti-inflation bias. There were almost no changes in the wording in the statement other than marginal changes to reflect the latest economic data. The Fed acknowledged that "economic growth slowed" in the first part of the year instead of the March 21 comment that "recent indicators have been mixed." The current and previous statement recognized that the "adjustment in the housing sector is ongoing." The wording on inflation is essentially unchanged, stating "core inflation remains somewhat elevated," as was similarly cited in the prior statement "recent readings on core inflation have been somewhat elevated." The May 9 statement retained the identical text that inflation is the main concern.

"Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures. In these circumstances, the Committee's predominant concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information."

The bottom line is that the Fed has shown no movement at all in terms of its concern that inflation is remaining too high. With no change of consequence in the Fed's statement, rate cuts are probably being nudged further out a little.

What is the Fed thinking on inflation' A recap of recent history on core inflation numbers is helpful. While the markets are focusing on the very latest and favorable core CPI and core PCE price index numbers, the Fed is remembering that we saw good core numbers late in 2006 – only to see a sharp rebound early in 2007. Yes, the core PCE price index came in flat in November and up 0.1 percent in December but then rose to 0.2 percent in January and 0.3 percent in February.

While the markets were excited about the flat (rounded down) core PCE price index in March and the 0.1 percent core CPI, the Fed has a longer memory and that is why the inflation bias remained in the FOMC statement.

In fact, the Fed is likely noticing some signs of strong liquidity that many are overlooking.  For example, both money supply and consumer credit numbers have been trending upward in recent months. After slowing over most of 2006, M2 money supply growth has picked up strength in recent months. M2 had been down to a year-on-year pace of 4 percent during 2005 but is now up to a 6.5 percent pace.

Consumer credit growth has been erratic on a monthly basis but clearly has been trending upward recently. Last week's data saw consumer credit spiking $13.5 billion in March, following a $5.5 billion rise the month before. On a year-on-year basis, consumer credit growth was 5.1 percent in March, compared to a recent low of 3.4 percent in April 2006. These growth rates in money supply and consumer credit are not signs of a tight monetary policy and may, in fact, signal a policy that is too loose according to some.

While markets have been pointing to signs of weaker economic growth, the upwardly sticky, volatile inflation numbers and the Fed retaining its anti-inflation bias have kept fed funds futures implied rates up. Indeed, traders expect the Fed to ease but not until late this year. The latest month of economic news has actually lowered the odds on rate cuts incrementally.

Retail sales dip but remain moderate on average

Retail sales came in weaker than expected for April and markets read into the latest report that the economy is softening further. However, the big picture suggests otherwise. Retail sales indeed were weak in April, down 0.2 percent, following a 1.0 percent jump in March. For April, key declines were in motor vehicles and general merchandise. Excluding autos, sales were unchanged after a 1.1 percent jump in March.  Gasoline stations, benefiting from higher prices, saw a jump. Excluding gas, retail sales posted a decline of 0.4 percent in April. Excluding both motor vehicles and gas stations, sales slipped 0.2 percent, following a 0.9 percent surge in March. While April sales were weak, it should be remembered that an early Easter stole sales away from April. Because Easter is a “floating” holiday (Easter’s timing depends on how the lunar cycle matches the spring equinox.  Easter is the first Sunday after the first full moon after the spring equinox.), the Commerce Department has difficulty seasonally adjusting retail sales in months around Easter.  For March and April on average, consumer spending remains moderately healthy. But we will need to see another month of data – away from Easter – to see the true trend. Still, the key point is that just as March overstated consumer strength, April overstated weakness.

Year-on-year, overall retail sales in April fell to up 3.2 percent from up 4.2 percent in March. Excluding motor vehicles, April’s year-on-year sales declined to up 3.6 percent, compared to up 4.4 percent in March. Excluding motor vehicles and gas station sales, year-on-year sales in April were up 4.0 percent, compared to up 4.3 percent in March.

Oil pumps up overall PPI but core remains subdued

Inflation seems to be on a dual track at the producer level – core is contained for now while food and energy remain a problem. The overall PPI surged 0.7 percent in April, following a 1.0 percent jump in March with both months seeing strong energy gains. However, the core rate was flat in April, also following no change in March.

For the overall PPI, strength was in energy. By special groupings, energy increased a monthly 3.4 percent in April, following a 3.6 percent boost in March. April’s rise was led by gasoline, up 8.2 percent; residential gas, up 0.5 percent; and home heating oil, up 4.8 percent. Consumer food prices moderated to a 0.4 percent increase, following a 1.4 percent advance in March. Nonetheless, the 0.4 percent gain is quite strong and is creating upward pressure on overall inflation.

Keeping the core rate steady primarily were declines in passenger car and light motor truck prices, which fell 1.0 percent and 0.5 percent, respectively.

The year-on-year rate for the overall PPI rose to up 3.2 percent in April from up 3.1 percent in March. The year-on-year core rate was unchanged at 1.6 percent.

Oil imports widen trade gap while exports set a record high

The U.S. trade deficit widened in March to a worse-than-expected $63.9 billion from a $57.9 billion shortfall in February. The consensus had expected a $60.1 billion gap. Imports rebounded 4.5 percent, largely reflecting an increase in the price of oil. Exports also rebounded 1.8 percent.

The merchandise trade gap (Census basis) widened to $67.6 billion from a revised $62.8 billion deficit in February. The goods gap excluding petroleum grew to a deficit of $45.5 billion from $44.3 billion in February.

On the import side, merchandise imports rose $6.9 billion, led by industrial supplies which jumped $5.0 billion and included oil imports. On the export side, merchandise exports rebounded $2.1 billion. Gains were led by industrial supplies and autos which rose $1.3 billion and $0.6 billion, respectively. Exports are now at a record high and continue to support U.S. manufacturing.

The March international trade report is a reminder of the significant impact that oil prices have on U.S. trade flows, on the dollar and on interest rates. The widening trade gap is putting downward pressure on the dollar and upward pressure on U.S. interest rates. The good news from the report is that exports remain strong, supporting U.S. manufacturing.

Import prices are not helping enough to ease inflation

Import prices remain on the strong side even after discounting petroleum. Import prices jumped 1.3 percent in April, following a 1.5 percent boost in March. Outside of petroleum, import prices are more moderate, rising 0.2 percent in April after a 0.3 percent gain in March. Certainly, import price inflation has eased overall but non-petroleum prices remain in an annualized 0 to 3 percent range. While this seems moderate, it is a sharp contrast with year-on-year declines of as much as 6 percent back in 2002.

Essentially, non-petroleum import prices are not helping to ease overall inflation currently. A weak dollar is likely to keep non-petroleum import prices from weakening and helping to pull down overall inflation in the U.S.

The bottom line

With the markets focusing on April’s dip in retail sales and the flat core PPI, the economy is probably a little stronger than markets believed at week end and inflation is probably still more of a problem than believed by many – the Fed notwithstanding. Nonetheless, the data still fit the soft landing scenario for now.

Looking Ahead: Week of May 14 through May 18

Highlights will be the consumer prices report on Tuesday and housing starts and industrial production on Wednesday.

Tuesday

The consumer price index jumped 0.6 percent in March, following a 0.4 percent rise in February, with energy components causing most of the damage. The core CPI eased to a 0.1 percent increase in March, following a 0.2 percent rise in February. After last week’s flat and favorable core PPI, markets will be hoping for a similar CPI number for April.

CPI Consensus Forecast for April 07: +0.5 percent
Range: +0.4 to +0.6 percent

CPI ex food & energy Consensus Forecast for April 07: +0.2 percent
Range: +0.1 to +0.3 percent

The Empire State manufacturing index slipped to 15.8 in April from 29.0 in March. Moderation was across the board. New orders and shipments fell noticeably while remaining in positive territory. Unfilled orders index slipped below zero.

Empire State Manufacturing Survey Consensus Forecast for May 07: 8.0
Range: 2.0 to 12.0

Wednesday

Housing starts surprised the markets with last month’s report of a 0.8 percent increase in March to a 1.518 million annual rate. Housing permits also posted a small gain in March but permits are not much of a leading indicator for starts – they generally coincide. While the underlying fundamentals for housing starts remain soft, unseasonably dry weather in parts of the U.S. may give starts a little unexpected lift in April.

Housing starts Consensus Forecast for April 07: 1.475 million-unit rate
Range: 1.40 million to 1.59 million-unit rate

Industrial production fell 0.2 percent in March, but manufacturing output jumped 0.7 percent.

Overall weakness was in utilities. We are likely to see a reversal of the utilities component but manufacturing is not likely to post a similar gain in April. From the earlier employment report for April, manufacturing production hours fell 0.4 percent, following a 0.5 percent rise in March, suggesting a weak month for manufacturing in April.

Industrial production Consensus Forecast for April: +0.2 percent
Range: +0.1 to +0.6 percent

Capacity utilization Consensus Forecast for April 07: 81.5 percent
Range: 81.3 to 81.7 percent

Thursday

Initial jobless claims for the week ending May 5 fell 9,000 to a much better-than-expected level of 297,000. The labor market continues to be tighter than most expected given the softness in some sectors of the economy. And the Fed’s key inflation concern currently is the tight labor market.

Jobless Claims Consensus Forecast for 5/12/07: 310,000
Range: 291,000 to 320,000

The general business conditions component of the Philadelphia Fed's business outlook survey index inched up to 13.2 in April from a level of 12.3 in March. The index is at relatively low levels compared with a year ago, but remains in the slightly positive range. The prices received index was nearly unchanged from March, but the prices paid index jumped sharply – likely related to energy costs.

Philadelphia Fed survey Consensus Forecast for May 07: 3.0
Range: 2.0 to 8.0

Friday

The Reuters/University of Michigan’s consumer sentiment index edged higher in mid-April to 89.2 from 88.9 in March. Current conditions rose to 111.1 from 109.1 but expectations fell to 75.1 from 76.0 in March. Consumer are seeing divergent trends – higher gasoline prices and higher stock prices among others – and these will certainly impact confidence.

Consumer sentiment Consensus Forecast for preliminary May 07: 87.0
Range: 85.5 to 88.0