Financials, real economy diverge as central banks pump liquidity
By R. Mark Rogers, Senior Economist, Econoday
August 10, 2007
Equities were rebounding last week including gains after Tuesday’s FOMC statement - until stocks plummeted Thursday on concern over a global liquidity crunch. Central banks in Europe were the first to respond by injecting additional reserves into the banking system and the Fed joined the parade with two separate injections on Thursday and three on Friday. It was clear the Fed was providing liquidity – not cutting interest rates. The extra liquidity calmed the markets, and equities actually ended up for the week.
Crude oil prices fell sharply last week. The big move last week was on Monday when the spot price for West Texas Intermediate fell $3.42 per barrel as hedge funds pulled out of long positions. That is, they decided their bet that crude prices would keep going up was not likely to happen. Net long positions were at record levels on July 31 and their unwinding this past week was the key reason for the drop. Concern over a softer economy also tied in with price weakness. Crude oil stocks fell more than expected according to weekly petroleum stocks report on Wednesday, but prices continued to dip on continued concern over a slowing economy.
The spot price per barrel for West Texas Intermediate was down last week by $4.01 per barrel to close at $71.47 per barrel. Crude is down $6.74 per barrel from the record high close of $78.21 on July 31.
Equities ended up last week despite some sharp swings during the week. Stocks started the week upbeat as all major indexes posted gains on Monday, Tuesday, and Wednesday. The Dow even jumped 286 points on Monday – the largest gain in almost 5 years. Monday’s gains were due in part to the belief that the financial sector had been oversold the week before and that subprime problems had been discounted enough. The sharp drop in oil prices and anticipation that the Fed would move closer to a neutral position in the next day’s FOMC statement also provided upward momentum for the day. Although the Fed on Tuesday retained its anti-inflation posture in its FOMC statement and left rates unchanged, it added a phrase acknowledging problems in the credit markets. This soothed the markets, boosting equities both Tuesday and Wednesday.
Equities plummeted on Thursday over concerns that subprime problems were spreading beyond lending firms. The Dow fell 387.18 points or 2.8 percent while the S&P dropped 44.4 points or 3.0 percent. The concern was that the value of mortgage-backed securities were simply too uncertain, and this led to credit markets becoming illiquid as buyers in this important market simply disappeared. Thursday’s problems started in Europe as a number of banks there halted withdrawals from investment accounts. All major European equity indexes declined as it became apparent that even European firms were holding significant amounts of mortgage-backed securities from the U.S. and were suffering asset losses. Financial firms were leery to lend to one another and a credit crunch ensued. Banks had a surge in overnight borrowing needs. The European Central Bank responded, loaning 94.8 billion euros ($130 billion) to ease the squeeze. The Fed later on Friday added $38 billion in reserves in three separate injections over the day. Earlier, the fed funds rate had spiked up to 6 percent and the Fed added reserves as needed to keep the rate near the 5-1/4 percent target. Additionally, the Fed issued a press statement that it would provide funds “as needed” to ensure the smooth operation of the banking system. Despite sharp intraday declines, equities rallied on Friday as a result of the Fed�s injections of liquidity along with that from other central banks and ended the week up.
Last week, major indexes rebounded despite the sharp drop on Thursday. The small caps came back the strongest after being battered the most the prior week. Major indexes were up as follows: the Dow, up 0.4 percent; the S&P 500, up 1.4 percent; the Nasdaq, up 1.3 percent; and the Russell 2000, up 4.4 percent.
Year-to-date last week, the Dow is up 6.2 percent; the S&P 500, up 2.5 percent; the Nasdaq, up 4.0 percent; and the Russell 2000, up 0.1 percent.
Interest rates were up notably last week except for the short end which dropped sharply. Rates made their first big move up on Wednesday as credit market worries were easing, flight to quality was reversing and stocks headed up. But rates fell sharply on Thursday on flight to quality as subprime problems reappeared with a vengeance – especially after France’s largest bank barred withdrawals from investment accounts with subprime loans. The Fed’s three-part injection of $38 billion in reserves calmed the markets and Thursday’s flight to quality unwound, pushing rates up sharply. Friday’s actions by the Fed represented the biggest one day injection of reserves since September 2001.
The Treasury yield curve rose last week except for the sharp drop on the near end. Yields were up as follows: 2-year T-note, up 4 basis points; 3-year, up 9 basis points; 5-year, up 12 basis points; the 10-year bond, up 13 basis points; and the 30-year bond, up 16 basis points. The 3-month T-bill dropped 29 basis points, possibly due to increased expectations of a near-term Fed easing. The 3-month T-bill competes with current and immediately expected changes in fed funds.
Rates generally rebounded last week as flight to quality unwound.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
Last week had very little economic data released and that may have been part of the problem with the financial markets – not enough “other” news to keep attention away from subprime issues.
Productivity and labor costs for the second quarter showed modest improvement. Second quarter productivity posted a 1.8 percent annualized increase, up from 0.7 percent in the first quarter. The faster growth in productivity reflected a jump in output which outpaced an increase in hours worked. Unit labor costs moderated somewhat, rising 2.1 percent annualized in the second quarter, following a 3.0 percent increase in the first quarter.
Year-on-year, productivity edged up to up 0.6 percent in the second quarter from up 0.4 percent the prior quarter. Year-on-year, unit labor costs in the second quarter stood at up 4.5 percent, compared to up 3.7 percent in the prior quarter.
While the productivity and unit labor cost numbers improved a little in the second quarter, the still high year-on-year numbers for unit labor costs must still be a concern for the Fed. The Fed is keen on seeing inflation rates stay down for an extended period of time before declaring victory and easing rates. With unemployment still low, the Fed will still be looking for signs of upward pressure on labor costs.
Import prices rose a greater-than-expected 1.5 percent in July but were up only 0.2 percent excluding petroleum products. Consumer goods excluding autos were well-behaved, rising only 0.1 percent for the latest month. Capital goods posted a 0.2 percent rise and autos increased 0.1 percent.
While the latest non-petroleum numbers seem modest, they are higher than negative numbers seen during much of last year. Year-on-year, non-petroleum import prices were up 2.8 percent in July, compared to up 2.6 percent in June and up 1.5 percent as recently as this past January. The recent low was 0.4 percent this past October. Import prices are not helping to ease inflation as much as in recent months. Overall import prices were up 2.8 percent in July, compared to 2.0 percent in June.
On Tuesday of last week – before all of the turmoil in the credit markets on Thursday and Friday - the Federal Open Market Committee released its meeting statement and kept the target for the federal funds rate unchanged at 5-1/4 percent and retained its anti-inflation bias. The only notable changes in the statement's wording was an acknowledgement of recent volatility in the financial markets and tighter credit conditions for some households and wording that downside risks have increased. While the anti-inflation bias has been retained, the acknowledgement of increased downside risks is actually a baby step toward a neural policy stance. Notably, the Fed still is in a wait and see stance on whether core inflation has come down on a sustainable basis.
The Fed emphasized that inflation is still the top priority and that the Fed is not ready to declare victory and ease rates. “Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.”
The Fed’s FOMC statement and its reaction to last week’s credit crunch should be viewed from the Fed’s perspective. The bottom line is that the Fed is in the inflation fighting and sustainable economic growth business – and not in the business of deciding market values of stocks or private debt.
Part of the FOMC statement was that the Fed would continue to monitor incoming economic data. Next week should help the markets focus on key data that the Fed also will be watching. Most likely, the data this coming week will offer reminders that the real economy is “OK” and hopefully the inflation numbers will be close to the Fed’s liking. Nothing would sooth the markets more than to get their attention on something other than subprime problems with moderate real economy data and soft inflation numbers.
Many now believe the Fed will be easing at its September FOMC meeting. In fact, as of last Friday, the fed funds futures market was pricing in almost 100 percent probability for an ease as a result of the credit market turbulence. But the Fed’s focus is long term. A Fed ease will depend on the real economy data and inflation numbers to indicate that the time is ripe. Currently, the real economy is doing quite well. “Joe six pack” and “Jane wine cooler” (yes, we made that one up, not wanting to be sexist) really are not that aware of the stock market problems nor the credit crunch. Private sector jobs just rose by 120,000 in July and the unemployment rate is still tight at 4.6 percent. Nonresidential construction is still strong and exports are booming. And the consumer is only moderating. Yes, inflation has posted some better numbers. But the Fed will be focusing on incoming data before a rate cut and will simply provide liquidity as needed to ease any resurgence of a credit crunch.
The latest credit crunch appears to have eased thanks to the Fed and other central banks. It is clear that the subprime problem is severe but as long as liquidity is maintained in the markets, the rest of the economy can hum along – and hopefully only a little under potential in order to keep the Fed happy. Equities – especially in the financial sector – will still be at risk until more firms disclose the full impact of any holdings of subprime-related assets.
This coming week brings a boatload of economic data, covering inflation with the PPI and CPI reports, the housing sector with the housing starts report, and manufacturing with regional surveys and the industrial production report.
Retail Sales fell 0.9 percent in June, following a 1.5 percent surge in May. Weakness was widespread but led by declines in motor vehicle sales, furniture, and building materials. Excluding auto, retail sales fell 0.4 percent in June while excluding service station sales, retail sales decreased 0.9 percent. Excluding both motor vehicles and gas stations, sales declined 0.4 percent. While a slowing in the consumer sector would be good from the Fed’s perspective, it is important that it only moderate – not fall off a cliff. A rebound in July is needed to sooth the markets.
Retail sales Consensus Forecast for July 07: +0.2 percent
Range: -0.3 to +0.4 percent
Retail sales excluding motor vehicles Consensus Forecast for July 07: +0.4 percent
Range: +0.1 to +0.5 percent
Business inventories rose 0.5 percent in May while business sales jumped 1.3 percent. In turn, the stock-to-sales ratio dropped 1 tenth to a very lean 1.26. It is good news that inventories in general are lean and pose little risk to the economy in terms of an inventory adjustment if consumer spending slows a little. Still, markets should always pay attention to inventory numbers to anticipate any impact on industrial production or imports. More recently, manufacturers’ inventories rose a moderate 0.3 percent in June.
Business inventories Consensus Forecast for June 07: +0.4 percent
Range: +0.3 to +0.6 percent
The producer price index fell 0.2 percent in June, following a 0.9 percent jump in May. The core rate firmed in June to a 0.3 percent increase, following a 0.2 percent rise in May. Given the recent spike in oil prices, we are likely to see a jump in overall producer prices in June but the core is likely to be moderate.
PPI Consensus Forecast for July 07: +0.1 percent
Range: -0.3 to +0.7 percent
PPI ex food & energy Consensus Forecast for July 07: +0.2 percent
Range: 0.0 to +0.2 percent
The U.S. international trade gap widened in May to $60.0 billion from $58.7 billion in April. Most of the worsening was in petroleum but the non-petroleum deficit widened also but only incrementally. We will likely see a price induced jump in the petroleum deficit and the overall deficit for June. That increase should be no surprise. Focus should be on exports which have been trending upward and supporting U.S. manufacturing. Merchandise exports rose $2.3 billion in May.
International trade balance Consensus Forecast for June 07: -$61.0 billion
Range: -$62.0 billion to -$58.6 billion
The consumer price index slowed to a 0.2 percent increase in June, following a 0.7 percent surge in May. The core CPI inflation rate firmed slightly with a 0.2 percent increase in June, following a 0.1 percent rise in May. For July, we may actually see a very soft overall number as gasoline prices came down though crude oil prices rose. More of that effect may be in August than July but enough may have occurred in July to have impacted the overall numbers.
CPI Consensus Forecast for July 07: +0.1 percent
Range: -0.1 to +0.2 percent
CPI ex food & energy Consensus Forecast for July 07: +0.2 percent
Range: +0.1 to +0.2 percent
The Empire State manufacturing index was relatively healthy in July at 26.5 as it was in June at 25.8. July’s increase in new orders with that index up more than 9 points to 26.5 suggests continued healthy production in August.
Empire State Manufacturing Survey Consensus Forecast for August 07: 18.0
Range: 14.0 to 19.0
Industrial production posted a 0.5 percent gain in June, following a 0.1 percent dip in May. By components in June, manufacturing was up a robust 0.6 percent, utilities were up 0.3 percent, and mining output jumped 0.5 percent. Recently, manufacturing surveys have been mixed with the Empire State index strong in July while the Philly Fed index softened. Additionally, July’s employment report showed that aggregate hours in manufacturing were unchanged in July – but swings in productivity can lead to output diverging from hours worked. Moderately healthy factory orders and lean inventories point to continued gains in industrial production. Overall capacity utilization rose to 81.7 percent from 81.4 percent in May.
Industrial production Consensus Forecast for July: +0.2 percent
Range: +0.1 to +0.5 percent
Capacity utilization Consensus Forecast for July 07: 81.8 percent
Range: 81.4 to 82.0 percent
Housing starts in June rebounded 2.3 percent, following a revised 3.4 percent decline in May. June's pace stood at a 1.467 million annual rate, which was down 19.4 percent on a year-on-year basis. In June, single-family starts edged down 0.2 percent while multifamily starts jumped 12.5 percent. Housing permits, however, fell 7.5 percent in June, following a 4.3 percent rise the month before. Housing permits were at a 1.406 million unit annual pace, down 25.2 percent on a year-on-year basis. Given the continued overhang in housing supply – new and existing homes – starts are likely to remain weak in July.
Housing starts Consensus Forecast for July 07: 1.410 million-unit rate
Range: 1.375 million to 1.460 million-unit rate
Initial jobless claims rose 7,000 in the Aug. 4 week to 316,000, lifting the four-week average 1,750 to 307,750. Continuing claims for the July 28 week rose 39,000 to 2.559 million.
Jobless Claims Consensus Forecast for 8/11/07: 315,000
Range: 310,000 to 321,000
The general business conditions component of the Philadelphia Fed's business outlook survey index slipped back to 9.2 in July from 18.0 in June, indicating expanding conditions but at a slower rate. But the six-month outlook jumped to 30.4 from 16.7 in June. With recent volatility in the markets, many may be giving the outlook portions of manufacturing surveys more attention than in the past.
Philadelphia Fed survey Consensus Forecast for August 07: +8.0
Range: -1.6 to +10.3
The Reuters/University of Michigan's consumer sentiment index stood at 90.4 in July, up from 85.3 in June. Expectations also showed strong improvement in July at 81.5 vs. 74.7 in June. Current conditions showed moderate strength at 104.5 vs. 101.9 in June. More recently, various financial and economic events have been moving in opposite directions on confidence – such as lower gasoline prices (a positive) and a drop in stock prices (a negative).
Consumer sentiment index Consensus Forecast for preliminary August 07: 88.0
Range: 86.0 to 92.5
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