Monetary policy worries weigh on equities, bonds
By R. Mark Rogers, Senior Economist, Econoday
June 8, 2007

Last week saw a modest amount of Fed Speak and only limited economic data. However, market psychology has shifted and many are now starting to believe the repeated Fed comments that too high inflation is still the predominant risk — especially since most of the economic data are now showing the U.S. economy on the somewhat strong side after a flat first quarter.

Recap of US Markets

OIL PRICES

Crude oil prices went on quite a roller coaster ride last week only to end little changed. Prices jumped over a dollar a barrel on Monday as a rare Arabian Sea cyclone threatened oil production and shipping in the Persian Gulf. Prices jumped again on Thursday by almost a dollar per barrel as Turkish military forces mounted an excursion into northern Iraq in pursuit of Kurdish militants working with separatists in Turkey. Turkish and U.S. officials worked to minimize the size of the operation and its potential impact on Iraqi oil production. On Friday, prices dropped by over two dollars per barrel to $64.76 as the selloff in equities raised doubts about the demand for oil and the threat from the cycle in the Persian Gulf faded as did the storm’s strength.

The spot price per barrel for West Texas Intermediate was down slightly for the week by $0.32 per barrel to close at $64.76 per barrel.

STOCKS

Equities were rocked hard Tuesday through Thursday over interest rate spikes due to bond market concerns that the odds are rising that the Fed may have to raise interest rates before cutting them. But the week started on a positive note Monday with most indexes posting a modest gain for the day. U.S. stocks edged higher despite a selloff in Chinese markets and a rise in oil prices. Merger news bolstered stocks. Also, Apple’s stock rose after announcing a June 29 launch date for its iPhone while Wal-Mart was boosted by the company’s announcement that it's slowing expansion and will conduct a $15 billion stock buyback. The Dow, S&P 500, and Russell 2000 closed at record highs. Tuesday was a turning point in market psychology as a stronger-than-expected ISM non-manufacturing report boosted interest rates and led more to believe that odds are rising that the Fed may have to raise interest rates.  On Wednesday, Fed Chairman Ben Bernanke spoke and reiterated his concern that the key risk to the economy was inflation remaining too high. The speech was warmed over from earlier presentations but the markets now his comments in the light of recent relatively strong economic data. All major indexes fell for the day.  The Dow fell 129.67. On Thursday, there were no significant economic data releases. Nonetheless, all major indexes fell for the third straight day and with the largest one day losses since March. The Dow fell 198.94. Thursday’s drop in the Dow was the largest point drop and percent drop since March 13 of this year. Equities did manage a partial rebound on Friday as investors saw equities as oversold from declines the prior three days.

Last week, all major indexes were down significantly - the Dow, down 1.8 percent; the S&P 500, down 1.9 percent; the Nasdaq, down 1.5 percent; and the Russell 2000, down 2.1 percent.

Year-to-date, the Dow is up 7.7 percent; the S&P 500, up 6.3 percent; the Nasdaq, up 6.6 percent; and the Russell 2000 is up 6.0 percent.

BONDS

The yield curve is up significantly for the week except on the near end. Rates actually nudged down at the start of the week as traders saw bonds as oversold on the prior Friday and from a flight to quality as investors fled Chinese stocks. On Tuesday, the strong ISM non-manufacturing report boosted interest rates and weighed heavily on stocks.  The only notable economic data for Wednesday was in the productivity report and productivity and labor costs were in line with expectations. Nonetheless, Fed Chairman Bernanke’s standard comments on inflation still being a risk, combined with Tuesday’s strong ISM report rattled the markets, boosting rates. Earlier in the day, the European Central Bank had raised rates, also leading to higher rates in the U.S.  On Thursday, rates jumped significantly and almost entirely on market psychology as investors saw a strong U.S. economy and little chance for the Fed to cut rates soon. Earlier in the day, the central bank of New Zealand had raised interest rates. Rates will little changed to down incrementally on Friday.

Net for the week the Treasury yield curve was up except for the 3-month T-bill. The far end was significantly higher. Yields were up as follows: 2-year T-note, up 3 basis points; 3-year, up 9 basis points; 5-year, up 13 basis points; the 10-year bond, up 16 basis points; and the 30-year bond, up 16 basis points. The 3-month T-bill slipped 1 basis point.

Over the last two weeks, yields on notes and bonds have risen sharply: 2-year T-note, up 14 basis points; 3-year, up 22 basis points; 5-year, up 26 basis points; the 10-year bond, up 25 basis points; and the 30-year bond, up 22 basis points. Over the last two weeks, the 3-month T-bill is down 9 basis points.

Bond rates are now at their highest since July 2006. Based on trading in fed funds futures, the Fed now is not expected to cut rates until early 2008.

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

Last week had a limited amount of news on the economy but apparently what little came out played into increasing fears that the Fed is not cutting rates soon but actually might be raising rates sooner than cutting rates.

Fed Speak – nothing new but the markets are now listening

Only a few Fed officials spoke on the economy last week. None of them, however, said anything new and generally repeated what was discussed in the latest FOMC minutes. But the markets are now seeing that economic data indicate that the economy is not going to remain soft and may strengthen beyond what is acceptable to the Fed.

Federal Reserve Chairman Ben Bernanke, addressing the International Monetary Conference in Cape Town, South Africa, spoke on "The Housing Market and Subprime Lending." In his prepared remarks, Bernanke indicated that inflation risks remain on the upside but that core inflation is expected to gradually come down.

"As expected, we have also seen a gradual ebbing of core inflation, although its level remains somewhat elevated. Despite recent increases in the prices of crude oil and gasoline, energy prices overall are below last year's peak; the rate of increase in shelter costs seems likely to slow, although the timing remains uncertain; and long-run inflation expectations, as derived from both surveys and market-based measures of inflation compensation, have remained contained. However, although core inflation seems likely to moderate gradually over time, the risks to this forecast remain to the upside. In particular, the continuing high rate of resource utilization suggests that the level of final demand may still be high relative to the underlying productive capacity of the economy."

Also speaking on the economy last week was Chicago Federal Reserve Bank President Michael Moskow (FOMC voting member). In an interview on CNBC, Moskow stated that inflation expectations are "well contained right now." Nonetheless, too high inflation is still the "predominant risk" to the economy. Moskow stated he believes current monetary policy is working but the Fed is continuing to monitor incoming data.

But within this context, U.S. markets were looking over their shoulder, so to speak, at central banks overseas. The European Central Bank and the central bank of New Zealand both raised interest rates last week. The Bank of England and the central bank of Australia had policy meetings last week with no rate changes but markets see them as preparing for rate changes in the near future.

Overall, central banks are speaking —including the Fed— but now the markets are really thinking that all of the statements about upside risks for inflation might actually be true.

ISM non-manufacturing survey surprises on the upside

The ISM non-manufacturing survey usually does not get a lot of market attention. The latest release was not the case. In a volatile report mostly showing strength, the Institute For Supply Management's non-manufacturing index jumped to 59.7 in May, its strongest reading since April 2006 and compared against 56.0 this past April. New orders, at 57.4, were the strongest since September and compare against 55.5 in April. The strength in the report was somewhat surprising and added to the view that the economy is back to healthy growth and at or possibly above potential. The ISM gain followed a relatively strong report the prior week in the ISM manufacturing report. Such overall strength goes against the Fed’s plan to keep growth modest and bring inflation down.

The ISM non-manufacturing price index continued its recent rise, increasing to 66.4 in May from 63.5 the prior month. May’s price index was the highest since 71.9 set in August of last year.

Productivity revised down while unit labor costs up

First quarter productivity was revised down to an annualized 1.0 percent from the initial estimate of 1.7 percent. This was much expected as the downward revision in productivity reflected a the sharp downward revision to first quarter GDP from an initial 1.3 percent annualized gain to a nearly flat 0.6 percent. Output in the productivity numbers has many — but not all —components in common with GDP. Year-on-year, productivity dropped to up 1.0 percent in the first quarter from up 1.6 percent the prior quarter.

Unit labor costs were revised up sharply to 1.8 percent from the initial estimate of 0.6 percent annualized. First quarter unit labor costs still were down from the 8.9 percent spike in the fourth quarter. Year-on-year, unit labor costs are down to up 2.2 percent, compared to up 4.0 percent in the fourth quarter.

The productivity report produced little real news given that the downward revision to GDP was expected to have such effects on productivity and unit labor costs. But the adverse revisions did help set a tone in the markets during the week that the Fed is not likely to cut rates any time soon and might even raise rates first.

International trade deficit unexpectedly shrinks

The U.S. trade deficit narrowed sharply in April to $58.5 billion from $62.4 billion in March. The import improvement was primarily outside of petroleum. Weakness was led by declines in imports of consumer goods and autos. Imports of non-auto capital goods also declined.

The merchandise trade gap (Census basis) narrowed to $64.6 billion from a revised $67.9 billion deficit in March. The goods gap excluding petroleum shrank to $42.3 billion from $45.5 billion in March.

On the import side, merchandise imports fell $3.3 billion. The surprise is that declines were led by categories other than petroleum. Declines were led by consumer goods, down $1.5 billion, and automotive, down $1.0 billion. While industrial supplies rose $0.3 billion, the crude oil subcomponent fell $0.3 billion.

On the export side, merchandise exports were flat. Gains were led by foods, feeds & beverages and by industrial supplies which rose $0.7 billion and $0.4 billion, respectively. Exports of capital goods excluding autos declined by $0.7 billion.

The oil trade deficit narrowed incrementally in April to $22.3 billion from $22.4 billion in March. Crude oil prices in April continued upward, rising to $57.28 per barrel from $53.00 per barrel in March.

The April trade report might be interpreted by some as indicating weak growth in the longer-run. Certainly, the dip in the trade deficit will boost the second quarter GDP number, but a decline in imports is usually associated with a drop in demand — indicating weak economic growth. However, imports have a long lag from purchase to delivery and the dip in imports may merely be a prior misjudgment of economic strength. With most data pointing to a strengthening in the U.S. economy, we can expect import growth to resume. Also, overseas economies are strong and we can expect export growth to continue.

The bottom line

There are further signs that the economy is strengthening. Economic growth may be too strong, leaving no gap between actual and potential growth. Too strong growth would keep inflation from settling into a low growth path as the Fed hopes and the Fed may have to raise rates to achieve its goals.

Looking Ahead: Week of June 11 through June 15

Next week’s pace for economic data picks up substantially. We get key readings on the consumer sector with retail sales on Wednesday and consumer prices on Friday. We also get to see how well the manufacturing surveys predicted manufacturing in May as industrial production comes out on Friday. The Fed’s Beige Book comes out on Wednesday and gives us the first hint on Fed thinking prior to the upcoming June 27-28 FOMC meeting.

Tuesday

The U.S. Treasury monthly budget report for April showed that the Treasury's surplus in April came in higher than expected at $177.7 billion. The Treasury's deficit so far this fiscal year is well under a year ago, at $80.8 billion vs. $184.1 billion. However, slowing economic growth is putting improvement in the deficit at risk. Looking ahead, the month of May typically shows a moderate deficit for the month. Over the past 10 years, the average deficit for the month of May has been $45.5 billion.

Treasury Statement Consensus Forecast for May 07: -$70.0 billion
Range: -$71.0 billion to -$38.0 billion.

Wednesday

Retail Sales were weak in April, declining 0.2 percent, following a 1.0 percent spike in March. April saw declines in key categories of motor vehicles and general merchandise. Gasoline stations sales jump, boosted in part by higher gasoline prices. Excluding gas, retail sales posted an even steeper decline of 0.4 percent. Excluding both motor vehicles and gas stations, sales slipped 0.2 percent, following a 0.9 percent surge in March. May’s employment report suggests that the consumer sector is still healthy as do recent initial jobless claims. These fundamentals should support retail sales in April.

Retail sales Consensus Forecast for May 07: +0.6 percent
Range: -0.3 to +0.8 percent

Retail sales excluding motor vehicles Consensus Forecast for May 07: +0.7 percent
Range: +0.3 to +1.2 percent

Import prices jumped 1.3 percent in April, following a jump of 1.5 percent in March. Both months were led by petroleum prices. But excluding petroleum, import prices remain contained, showing a 0.2 percent gain in April and a 0.3 percent gain in March. Oil prices leveled off in May but at high levels. With foreign economies running hot and oil prices feeding into costs of production, even non-petroleum import prices are starting to see upward pressure. And a weak dollar is not helping.

Import prices Consensus Forecast for May 07: +0.3 percent
Range: 0.0 to +1.0 percent

Business inventories eased in March for the biggest month-to-month decline in almost two years, slipping 0.1 percent, following a 0.2 percent rise in February. March’s dip in inventories was well below the 1.4 percent jump in business sales and pushed the stock-to-sales ratio to a very lean 1.27. More recently, factory orders – a component that goes into business inventories – rose 0.5 percent in April. Also, retail sales fell 0.2 percent in April. These suggest a possible rise in inventories in April.

Business inventories Consensus Forecast for April 07: +0.3 percent
Range: +0.2 to +0.5 percent

The Beige Book being prepared for the June 27-28 FOMC meeting is released Wednesday afternoon.

Thursday

The producer price index jumped in April due to a spike in energy components while the core PPI held steady. The overall PPI surged 0.7 percent in April, following a 1.0 percent jump in March. The core rate was flat in April, also following no change in March. However, commodity prices have firmed recently and energy costs – among others – could be pushing on the core. Rising demand overseas also is concern.

PPI Consensus Forecast for May 07: +0.6 percent
Range: +0.2 to +1.0 percent

PPI ex food & energy Consensus Forecast for May 07: +0.2 percent
Range: +0.1 to +0.2 percent

Initial jobless claims data continue to point to tight conditions in the labor market. Initial claims fell 1,000 in the June 2 week to a nearly as-expected 309,000, a level right at the four-week average of 307,250. Despite the Memorial Day weekend, the Labor Department said there were no special factors in the week. Continuing claims did hint at weakness, up 72,000 in the May 26 week though the four-week average actually slipped slightly to 2.498 million. Financial markets showed no reaction to the data.

Jobless Claims Consensus Forecast for 6/9/07: 310,000
Range: 305,000 to 315,000

Friday

The consumer price index increased 0.4 percent in April, following a 0.6 percent jump in March. Another rise in energy costs and in food prices were the main reasons for the strong overall CPI number. The core CPI firmed slightly with a 0.2 percent increase in April, following a 0.1 percent rise in March. We can expect oil prices to keep upward pressure on the overall CPI in May but markets will be focusing on the core figure. We have had two goods months of modest core inflation – but we have seen that before, only to have a rebound in core inflation. A third month of 0.2 percent or less would be welcome news for the markets.

CPI Consensus Forecast for May 07: +0.6 percent
Range: +0.4 to +0.8 percent

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

The Empire State manufacturing index showed modest strength in its May reading, rising to 8.0 from 3.8 in April. New orders also showed modest strength, at 8.0 vs. April's 3.9. Regional manufacturing surveys have recently been showing an improvement in manufacturing. Another healthy month would further confirm that manufacturing is coming out of its first quarter doldrums.

Empire State Manufacturing Survey Consensus Forecast for June 07: +12.5
Range: +9.0 to +15.0

The U.S. current account deficit narrowed in the fourth quarter to $195.8 billion vs. $229.4 billion in the third quarter. The goods & services gap narrowed sharply to $178.6 billion vs. the third quarter's $201.4 billion. Another plus, private foreign investors were big purchasers of U.S. Treasuries in the quarter.

Current account Consensus Forecast for Q107: -$201.0 billion
Range: -$208.7 billion to -$193.8 billion

Industrial production jumped 0.7 percent during April, following a 0.3 percent dip the prior month. Capacity utilization rose 4 tenths in the month to a still moderate 81.6 percent. More recently, manufacturing indicators have been mostly positive. Durable goods orders rose 0.6 percent in April and both ISM surveys have been moderately healthy. However, manufacturing production hours declined 0.3 percent in May as reported in the employment situation. But this has not been a very good indicator for manufacturing recently – possibly due to increases in cyclical productivity.

Industrial production Consensus Forecast for May: +0.2 percent
Range: -0.2 to +0.5 percent

Capacity utilization Consensus Forecast for May 07: 81.6 percent
Range: 81.3 to 81.8 percent

The University of Michigan’s Consumer sentiment index was revised down to 88.3 for May from the mid-month estimate of 88.7. This still was improvement from the April final figure of 87.1.

Consumer sentiment Consensus Forecast for preliminary June 07: 87.7
Range: 86.9 to 90.0