Markets rally though Bernanke doesn't tip hand
By R. Mark Rogers, Senior Economist, Econoday
August 31, 2007
This past week continued to be roiled by subprime fears as volatility was rampant in both equities and bonds. But by week's end both stocks and bonds rallied on the belief that the Fed would take more action to address subprime liquidity problems – including cutting the fed funds rate on September 18 and more later this year. Fed Chairman Bernanke’s remarks at a Federal Reserve economics conference on subprime lending issues, however, gave no indication either way on whether the Fed is going to cut rates soon. Meanwhile, economic data continue to show a generally healthy economy outside of housing and with inflation currently subdued.
Crude oil prices jumped sharply this past week. The spike during the week came on Wednesday after the government’s weekly petroleum stocks report — the spot price for West Texas Intermediate jumped $1.78 for the day. Both U.S. gasoline inventories and crude oil inventories fell sharply in the week ended August 24. U.S. gasoline stocks are at their lowest days of demand on record – just 20 days of demand in supply.
The spot price for West Texas Intermediate jumped $2.96 per barrel for the week to close at $74.30 per barrel. Friday’s close was still $3.91 per barrel lower than the record high of $78.21 per barrel set this past July 31.
The weekly gain occurred despite a lack of significant hurricane activity, the winding down of the summer driving season, OPEC stating it will keep production steady, and concern that housing and subprime trouble may slow the U.S. economy.
Equities swung sharply during the week to end mixed. Blue chips ended down marginally, small caps down moderately, but techs were up moderately. Equities dipped on Monday – largely due weak existing home sales that reminded the markets of housing problems. Stocks sold off heavily on Tuesday as the August 7 FOMC minutes were more hawkish than expected. But stocks rebounded sharply on Wednesday on encouraging comments from Bernanke who in a letter to Democratic Senator Charles Schumer of New York indicated that the Fed will take whatever steps necessary to ensure the orderly functioning of financial markets. Some saw the letter as a sign the Fed is edging closer to an easing while others saw no new information in the letter. Stocks were mixed on Thursday as the markets awaited Bernanke’s Friday presentation on housing and subprime issues before a Federal Reserve internal conference at Jackson Hole, Wyoming. Bernanke’s comments on Friday were seen by most equity and bond traders as a slight movement toward a rate cut on September 18. However, a significant minority saw Bernanke’s comments as non-committal. But what lifted equities the most on Friday was President Bush’s announcement of a plan to help low income home owners refinance their mortgages through the Federal Housing Administration.
The tech sector was the winner last week with support largely due to its current perception as a safe harbor. Winners included Apple, Seagate, Sun, Intel, Cisco, and Gateway.
Last week, major indexes were mixed. Most major indexes were down as follows: the Dow, down 0.2 percent; the S&P 500, down 0.4 percent; and the Russell 2000, down 0.8 percent. The Nasdaq rose 0.8 percent for the week.
It was during the two weeks immediately after the Fed’s discount rate cut that equities rebounded enough to put major indexes back in the green in August after being down early in the month. A last-day-of-the-month boost from a good personal income report, no negative news from Bernanke, and President Bush announcing his plan to help housing also helped. For the month, the Dow was up 1.1 percent; the S&P 500, up 1.3 percent; the Nasdaq, up 2.0 percent; and the Russell 2000 up 2.2 percent.
Year-to-date, the Dow is up 7.2 percent; the S&P 500, up 3.9 percent; the Nasdaq, up 7.5 percent; and the Russell 2000 is up 0.7 percent.
Interest rates were quite volatile this past week but ended the week down. The 3-month T-bill showed the most volatility as investors kept changing their minds over the need for flight to quality over subprime problems in the credit markets and weakness or not in equities. The 3-month T-bill rose sharply on Monday as investors unwound a significant part of the prior week’s huge flight to safety. But on Tuesday, the Fed’s FOMC minutes were more hawkish than expected, weighing on equities and sending funds into safe-haven Treasuries. Rates headed back up on Wednesday as monies flowed back into stocks on Fed Chairman Bernanke’s letter to Senator Schumer. Rates fell on Thursday on flight to quality as markets awaited Bernanke’s Friday presentation on housing and subprime issues. Rates fell on Friday as investors saw comments by both Bernanke and President Bush as being favorable for the credit market and housing.
The Treasury yield curve fell last week. Yields were down as follows: 3-month T-bill, down 9 basis points; 2-year T-note, down 16 basis points; 3-year, down 15 basis points; the 5-year, down 17 basis points; the 10-year bond, down 9 basis points; and the 30-year bond, down 6 basis points.
The 3-month T-bill had trouble finding its moorings this past week. The 3-month T-bill was up 27 basis points on Monday before falling a cumulative 55 basis points the next three days and rebounding 19 basis points on Friday. However, markets were thin heading into the Labor Day weekend.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
Last week brought a number of economic indicators, most of which portrayed a healthy economy. But most of the numbers were overshadowed by the release of the minutes of the August 7 FOMC meeting, remarks by Fed Chairman Bernanke on Friday morning on subprime issues, and remarks by President Bush on a modest program to help low income home owners in distress over higher interest rates.
While the numbers are backward looking, the first revisions to second quarter GDP indicate that the economy was stronger than previously believed prior to the subprime problems of July and August. Second quarter real GDP was revised up to an annualized 4.0 percent from the initial estimate of 3.4 percent. The second quarter pace followed a nearly flat 0.6 percent annualized increase in the first quarter. The upward revision to the latest quarter makes it the strongest gain since the 4.8 percent pace for the first quarter of 2006. The second quarter GDP price index was left unchanged from the initial estimate of 2.7 percent – also meeting the market forecast. The core PCE price index was revised to an annualized 1.3 percent for the second quarter, compared to the initial estimate of 1.4 percent.
The upward revision to the initial estimate for the second quarter is due to greater increases in business investment and net exports than initially estimated.
For the second quarter overall, the acceleration in growth primarily was due to a jump in nonresidential structures investment, stronger exports, and a decline in imports. Residential investment was negative but less so than in prior quarters. However, personal consumption growth slowed notably.
Year-on-year, real GDP growth stood at 1.9 percent in the second quarter, compared to up 1.5 percent in the first quarter. Year-on-year, the GDP price index slowed to up 2.7 percent in the second quarter from up 2.9 percent in the prior quarter. The core PCE price index growth rate came in at up 2.0 percent in the second quarter, down from up 2.4 percent in the first quarter.
Also indicating that the economy – outside of housing - was quite healthy heading into the recent subprime turbulence was a jump in second quarter corporate profits. Corporate profits in the second quarter advanced to a $1.444 trillion annual rate from the first quarter’s $1.363 trillion. Second quarter profit growth jumped to an annualized 25.5 percent, following an 8.2 percent annualized increase in the first quarter. Profits are after tax but without inventory valuation and capital consumption adjustments. Corporate profits are up 4.4 percent on a year-on-year basis, compared to up 4.3 percent in the first quarter.
Two areas of concern about the economy have been how well the consumer sector is holding up and whether core inflation is staying down. The July personal income report indicates that the consumer is doing quite well and core inflation – for now – is subdued. Personal income growth continued strong in July, posting a 0.5 percent increase, following a 0.4 percent boost in June. Within personal income, the wages and salaries component grew 0.5 percent in July, matching June’s gain. Personal income year-on-year rebounded to up 6.6 percent from up 6.1 percent in June.
Importantly, there was some strengthening in consumer spending which had languished in June. Personal consumption rose 0.4 percent in July, following a 0.2 percent increase in June. Spending was led by nondurables, which rose 0.4 percent in July, while durables and services advanced 0.3 percent and 0.2 percent, respectively.
There was good news on the inflation front as the core PCE price index rose 0.1 percent, down from June’s 0.2 percent increase. The overall PCE price index also moderated, rising 0.1 percent in July, following a 0.2 percent increase in June. The core PCE price index on a year-on-year basis was unchanged at 1.9 percent while the overall PCE price index slipped to 2.1 percent from 2.3 percent in June. The core PCE price index has been inside the Fed’s implicit target zone of 1 to 2 percent for two consecutive months.
Of course, a key issue for the Fed is whether their forecast for inflation is for it to stay down. Fed Chairman Bernanke acknowledged last week that after the credit crunch and financial losses during the first half of August that there is much greater uncertainty over the outlook. But this past week’s strong personal income report suggests that third quarter real GDP growth has a good chance of exceeding potential. And that would be a concern for the Fed. While there has been a steady downward trend in core year-on-year inflation, the numbers have been a good deal more volatile on the margin. On a 3-month-ago annualized basis, the core PCE price index now stands at a moderate 1.6 percent but had been as low as 1.1 percent in May and as high as 2.7 percent this past February.
Sales of existing homes held steady in July, at an annual pace of 5.750 million vs. 5.760 million in June. Still July's rate is the lowest in nearly five years.
Supply of existing homes on the market has worsened to a record 9.6 months. Swollen supply will continue to pressure builders and construction payrolls. Existing home prices slipped 0.1 percent in the month to $228,900 for a year-on-year decrease of only 0.6 percent. But the median price likely is being supported by a reduction in sales of homes on the low end.
Manufacturing continues to provide support for healthy economic growth. Factory orders surged in July, up 3.7 percent and led by an 11.0 percent spike in transportation orders that reflects strength in aircraft orders and unusual strength in vehicle orders. But there's plenty of strength outside of aircraft and vehicles, with orders up 2.4 percent excluding transportation.
Other readings include a 2.6 percent jump in overall shipments, which will show up in exports and in business equipment investment in part. In another good sign, inventory growth at 0.2 percent is well behind shipment growth and indicates that manufacturers may be struggling just a little to keep up with demand. The inventory-to-shipment ratio fell to 1.21 in July from 1.24 in June, a reminder that inventories will have to be built back up to meet demand. Unfilled orders also jumped sharply in July – indicating a build up of momentum in manufacturing.
Contrary to what many pundits were saying around the time of the August 17 cut in the discount rate, the Fed already had been closely watching the turmoil in the financial markets prior to the August 7 FOMC meeting when the Fed voted to retain its anti-inflation bias. The minutes of the FOMC meeting held on August 7, 2007 indicate that the FOMC had extensive discussion of the problems in the financial markets. The FOMC noted that further turbulence in the financial markets could warrant a policy response.
“However, a further deterioration in financial conditions could not be ruled out and, to the extent such a development could have an adverse effect on growth prospects, might require a policy response. Policymakers would need to watch the situation carefully. For the present, however, given expectations that the most likely outcome for the economy was continued moderate growth, the upside risks to inflation remained the most significant policy concern.”
The minutes make it quite clear that the Fed was keeping its finger on the pulse of the financial markets. The Fed did lower its forecasts for both real economic growth and for core inflation in 2007. But because continued strong growth and high resource utilization, the Fed left its forecast for core inflation unchanged for 2008.
Despite the turbulence in the financial markets, the Fed was focusing more on the real economy and on inflation trends. These included the belief by the Fed that inflation risks were still the primary concern.
“In addition, the Committee agreed that the statement should again note that readings on core inflation had improved modestly in recent months but did not yet convincingly demonstrate a sustained moderation of inflation pressures, and that the high level of resource utilization had the potential to sustain inflation pressures. Against this backdrop, members judged that the risk that inflation would fail to moderate as expected continued to outweigh other policy concerns.”
The bottom line is that the Fed had already thought about the potential need for a rate cut at the August 7 meeting but determined that more incoming information on inflation or a worsening in the financial markets would be needed before cutting rates. The minutes can either be seen to confirm the view that a rate cut on September 18 — the next FOMC meeting — is a done deal or that incoming data — such as the next employment report or retail sales report —will determine the Fed’s next move.
While financial markets had hoped that Federal Reserve Chairman Ben Bernanke would provide more clarity on whether or not the FOMC will cut interest rates on September 18, such did not happen with Bernanke’s comments before a Federal Reserve economic conference at Jackson Hole, Wyoming. But the Fed chairman did state that the Fed has recognized the greater seriousness of the current liquidity problems related to subprime lending problem. Bernanke stated the Fed will act as needed but that it is not the Fed’s job to rescue those in the financial sector from bad decisions. But he said it is the Fed’s job to ensure that those decisions do not hurt economic policy and that means the Fed stands ready to cut interest rates if needed for overall economic needs.
Bernanke acknowledged that the financial losses globally were far more than anticipated. He sees that investor uncertainty has increased significantly due to the difficulty in evaluating the value of various structured financial products. But he sees some of the investor reluctance as good.
“More generally, investors may have become less willing to assume risk. Some increase in the premiums that investors require to take risk is probably a healthy development on the whole, as these premiums have been exceptionally low for some time. However, in this episode, the shift in risk attitudes has interacted with heightened concerns about credit risks and uncertainty about how to evaluate those risks to create significant market stress.”
But because of the market stress, the Fed has become concerned about ensuring that financial markets function in an orderly manner and that was the key purpose behind the August 7 discount rate cut.
Bernanke appeared to still be deliberately portraying a balanced position in regard to implying whether or not the Fed is headed toward a cut in the fed funds rate at the September 18 FOMC meeting. He stated that “The Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets.” But he also was worried about the morale hazard issue — the Fed should not encourage bad behavior in the financial markets. “It is not the responsibility of the Federal Reserve ― or would it be appropriate ― to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy.”
In his final comments on the policy portion of his presentation, the Fed Chairman acknowledged that economic data from recent months or quarters are less useful than usual and that the Fed will be giving greater emphasis to anecdotal information and more current data. What many did not pick up on in his speech is that he stated this in the context of the Fed’s forecasts of economic activity and inflation. The Fed is still taking the long view. There are greater odds of a Fed cut on September 18 but the Fed does not appear to be rushed.
Outside of housing, economic data show a relatively strong economy and one with inflation subdued at least for now. The Fed has shown itself willing to inject liquidity as needed in the financial markets. But the Fed also seems to be saying that there is a difference between ensuring orderly financial markets vs. cutting interest rates to achieve the Fed’s two goals of low inflation and healthy but sustainable economic growth.
This coming week may help clarify whether the Fed is likely to cut interest rates at its September 18 FOMC meeting. We are starting to get economic data over the period of the financial turmoil in August. For August, we will see the two ISM surveys, motor vehicle sales, and the all-important employment report. Plus, the Fed releases its Beige Book on Wednesday in preparation for its September 18 FOMC meeting.
Labor Day holiday in the U.S. All markets are closed in the U.S.
Construction spending fell 0.3 percent in June, following a 1.1 percent surge in May. The June drop in construction was led by private residential outlays with public construction outlays also declining. Nonresidential construction continued its uptrend. We can expect continued weakness for residential outlays in July, given the on-going oversupply of houses. Nonresidential and public construction spending are likely to post gains in line with good fundamentals in those sectors.
Construction spending Consensus Forecast for July 07: 0.0 (flat) percent
Range: -0.6 to +0.2 percent
The Institute for Supply Management’s manufacturing index slipped in July to 53.8, down 2.2 points from June but still pointed to firm conditions. The composite index is likely to hold to a healthy level given that new orders in this survey were still solid in last month’s report. The Commerce Department’s durable goods orders was very strong for July, also pointing to strength in the manufacturing sector.
ISM manufacturing index Consensus Forecast for August 07: 53.0
Range: 51.0 to 56.5
Motor vehicle sales were soft once again in July. Domestic-made vehicles sold at an annual rate of 11.5 million, down from 11.6 in June and well down from a 12.2 million rate in May. Sales of imports were at a 4.0 million rate, combining for a 15.5 million total rate, down from 15.4 million in June and the lowest rate in nearly two years. Given that gasoline prices are down, we might see a nudge up in motor vehicle sales but consumer confidence has been slipping and could push sales down.
Motor vehicle sales Consensus Forecast for August 07: 12.0 million-unit rate
Range: 11.8 to 12.3 million-unit rate
The Beige Book being prepared for the September 18 FOMC meeting is being released by the Fed at 2:00 p.m. Eastern Time today. The Beige Book will get much more attention than usual due to the market debate over whether the Fed is going to cut the fed funds rate at this FOMC meeting and after Fed Chairman Ben Bernanke indicated last week that the Fed will be giving anecdotal information greater weight.
Initial jobless claims rose 9,000 in the Aug. 25 week to 334,000, the highest level since mid-April. The four-week average is confirming a softening in the labor market, up 6,250 to 324,500. However, given that we have seen earlier announcements of large lay-offs in the financial sector, the latest claims numbers may suggest tight conditions outside of the financial sector.
Jobless Claims Consensus Forecast for 9/1/07: 330,000
Range: 325,000 to 342,000
Nonfarm productivity and unit 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. Unit labor costs moderated somewhat, rising 2.1 percent annualized in the second quarter, following a 3.0 percent increase in the first quarter. More recently, second quarter real GDP was revised up significantly to a 4.0 percent annualized pace from the initial 3.4 percent estimate. The upward revision to GDP will likely carry over to an upward revision to productivity and downward revision to unit labor costs since the output portion in these numbers depend heavily on the same source data as GDP.
Nonfarm Productivity Consensus Forecast for revised Q2 07: +2.5 percent
Range: +1.0 to +2.6 percent
Unit Labor Costs Consensus Forecast for revised Q2 07: +1.5 percent rate
Range: +1.0 to +2.0 percent rate
The business activity index from the ISM non-manufacturing survey slowed noticeably in July, falling back to 55.8 from June's very strong 60.7. New orders also moderated, declining to 52.8 from 56.9 in June. While the numbers are still in the positive range, they clearly suggest more moderate growth in non-manufacturing.
Business activity index Consensus Forecast for August 07: 54.5
Range: 52.0 to 56.7
Nonfarm payroll employment increased by 92,000 in July, after posting advances of 126,000 in June and 188,000 in May. However, most of the softening in payrolls in July was in a 28,000 drop in government payrolls. Private payrolls rose by 120,000 in July after a 107,000 boost in June. The decline in government jobs primarily was in local and state government education categories that can have difficult-to-adjust seasonal swings at the start or end of summer. On the inflation front, average hourly earnings increased 0.3 percent in July, after posting a 0.4 percent boost in June. Turning to the household survey, the civilian unemployment rate edged up to 4.6 percent in July from 4.5 percent the month before. Markets will be giving the August employment report heavy scrutiny given that it will be one of the key reports that may tip the balance on whether the Fed cuts interest rates at its September 18 FOMC meeting. What could keep the Fed on hold — perhaps a payroll gain over 120,000, a dip in unemployment, and/or rise in average hourly earning of 0.3 percent or more.
Nonfarm payrolls Consensus Forecast for August 07: +100,000
Range: +35,000 to +150,000
Unemployment rate Consensus Forecast for August 07: 4.7 percent
Range: 4.6 to 4.8 percent
Average workweek Consensus Forecast for August 07: 33.8 hours
Range: 33.8 to 33.9 hours
Average hourly earnings Consensus Forecast for August 07: +0.3 percent
Range: +0.2 to +0.6 percent
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