Equities ecstatic but bonds fret
By R. Mark Rogers, Senior Economist, Econoday
September 21, 2007
This past week the Federal Reserve’s monetary policy group, the Federal Open Market Committee, cut two key short-term interest rates by 50 basis points. Equity markets in the U.S. and overseas jumped on the news. But while short-term rates headed down, the bold move by the Fed sent other markets reeling as oil and gold prices jumped, the dollar plummeted, and long-term interest rates in the U.S. rose significantly. Many markets were not acting as if the Fed had achieved a sustained rate of low inflation but in fact were acting as if the Fed had acted too hastily in cutting rates, leaving the anti-inflation job unfinished. But equities and other markets are still betting on more Fed rate cuts this year, which is clearly seen in fed funds futures which are betting that the fed funds target rate will be significantly lower by this time next year. Meanwhile, economic data are mixed, showing moderate growth overall with no compelling case for impending recession.
Oil prices continued their recent upward spiral as prices set new record highs on each day of this past week. The price increases were due to a combination of factors – the big one being the Fed’s cut in interest rates. The cut in interest rates led traders to believe that U.S. economic growth would be stronger. In fact, this effect pushed spot prices up even on Monday by $1.47 per barrel in anticipation of the Fed rate cut. Prices also got upward support on Monday from talk of more hurricanes coming. Crude advanced another $0.94 per barrel on Tuesday on the actual news of the Fed’s rate cut. But after the rate cut, a sharp drop in the dollar through most of the week pushed oil prices up. Oil is priced in dollars and foreign investors found oil to be cheap in non-dollar currencies. Foreign funds jumped into the oil markets heavily. The decline in the dollar also gives OPEC an incentive to keep prices up – the dollar-based revenues are not as valuable in other currencies. Oil spiked $1.39 per barrel to $83.32 on Thursday but the big reason was the expiration of the October crude contract. Throughout the week, hurricane talk supported prices as well as geopolitical events, the latter including Israel’s quick military action in Syria and comments by French officials that more sanctions need to be taken against Iran over nuclear development. Prices remained firm on Friday, with upward pressure from a weak dollar nudging the price for spot crude to another record high — $83.42 per barrel.
From the Fed’s perspective, oil prices are likely to remain high and remain an inflation issue since economic growth remains strong world wide and the dollar is not likely to reverse soon — especially if the Fed continues to cut rates as many expect.
The spot price for West Texas Intermediate jumped $4.32 per barrel for the week to close at $83.42 per barrel.
Equities rose smartly this past week, buoyed by euphoria over the size of the Fed’s interest rate cut this past Tuesday. But stocks started the week down on Monday over fears the Fed would not ease enough. Bank stocks were down notably ahead of the Fed and ahead of earnings reports later in the week. Stocks surged Tuesday afternoon with the Dow rising 335.97 points, the largest point gain since the 378.28 boost on October 15, 2002. Percentage wise, the Dow jumped 2.5 percent, the biggest single day gain since 2.7 percent on April 2, 2003. But it was the small caps that really responded the most to the Fed’s rate cut. The Russell 2000 surged 4.0 percent for the day. But for the Dow, gains were led by financials, including JP Morgan, American Express, and Citigroup. Cyclicals and consumer oriented companies also did well – such as Alcoa, Caterpillar, and Wal-Mart. The euphoria from the Fed rate cut continued on Wednesday with small caps leading the way – the Russell 2000 posted a gain of 1.3 percent. Cyclicals also were strong — the lower short-term interest rates are helping interest rate sensitive sectors. However, the Fed rally ended on Thursday due to concern over the sharp decline in the dollar post-Fed and also over the jump in oil prices. A number of key financial firms announced weak profits – notably Bear Stearns — weighing on stocks. On Friday, strong earnings from Oracle and Nike put the markets back in an upbeat mood, lifting stocks notably for the day. Overall, we saw significant upward movement in equities from the Fed’s rate cut with those benefiting the most being small caps, financials, cyclicals, and the consumer sector. And, importantly, despite mixed earnings reports from the financial sector, the fact that there were no major surprises related to subprime holdings was a major boost to market confidence. Many are concluding that the worst of the subprime problems is behind us and that should make the credit markets more liquid and support equities.
Last week, major indexes were up. Major indexes were up as follows: the Dow, up 2.8 percent; the S&P 500, up 2.8 percent; the Nasdaq, up 2.7 percent; and the Russell 2000, up 3.8 percent.
Year-to-date, the Dow is up 10.9 percent; the S&P 500, up 7.6 percent; the Nasdaq, up 10.6 percent; and the Russell 2000 is back in the green, up 3.2 percent.
While equity markets were ecstatic about the Fed’s 50 basis point cut in the fed funds rate target this past week, the bond market eventually gave the Fed a vote of no confidence later in the week as long rates jumped in the U.S. over fears of a rebound in inflation. Rates were flat on Monday except for the 3-month T-bill as investors sat on the sidelines waiting on the Fed’s meeting statement on Tuesday. The bill rose on concern the Fed might not cut enough. Tuesday’s rate cut pulled rates down except for rate increases in the long bonds which were up over inflation concerns. On Wednesday, despite a dip in the headline CPI for August and a decline in housing starts data, notes and bond rates were up on inflation fears as the dollar weakened further and oil prices continued to rise. Thursday saw the biggest jump in rates as all notes and bond rates were up by double digit basis points. Inflation was a concern but there also were worries that Saudi Arabia might cut back on its Treasury holdings. This fear was raised in part by Saudi Arabia’s refusal to match the Fed’s rate cut. The oil kingdoms in the Middle East tend to tie their short-term interest rates with those of the U.S. After the Fed rate cut, the United Arab Emirates and Kuwait matched the interest rate cut but Saudi Arabia did not. Friday saw a mild partial reversal in rates as foreign investors saw the higher Treasury rates as attractive and pushed prices up somewhat. Prices also were lifted by comments from Federal Reserve Vice Chairman Donald Kohn that the Fed likely would not have cut rates as much as it did if housing prices had not been so weak – indicating that the housing sector was weaker than the Fed had anticipated.
But the bottom line for the week is that the Fed’s rate cut has renewed fears of a rebound in inflation further down the road. Bond investors particularly have noted the sharp drop in the dollar, higher oil prices, and higher commodity prices.
Treasury yields were up as follows in the week: 2-year T-note, up 2 basis points; 3-year, up 7 basis points; the 5-year, up 13 basis points; the 10-year bond, up 17 basis points; and the 30-year bond, up 17 basis points. The 3-month T-bill rate declined by 27 basis points.
The 3-month T-bill fell further last week, pulled down by the Fed rate cut. Inflation fears, however, sent long bonds sharply in the other direction.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
Last week saw mixed reactions in the financial markets over the Fed’s interest cut while the economy remained on recent trends. But the highlight clearly was the Fed’s bold 50 basis point cut in the fed funds target rate and in the Fed’s discount rate. And almost incidentally, the most recent PPI and CPI reports were mild overall and supported the Fed’s move.
The Federal Open Market Committee gave the markets what they wanted – a 50 basis point cut in the fed funds rate target and also tossed in a 50 basis point cut in the discount rate. The vote was unanimous for both. The fed funds target rate is now 4-3/4 percent and the discount rate is now 5-1/4 percent. The Fed made the cuts to forestall adverse effects on the economy from financial disruptions but still sees inflation as a risk. The only disappointment with the Fed’s actions was that the statement gives no hint of immediately pending additional rate cuts. Based on the FOMC statement, the Fed primarily moved to try to get ahead of the curve of deteriorating economic conditions. “Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.”
The Fed kept the gap between the fed funds target rate and the primary credit discount rate — or what is now called the discount rate colloquially — at 50 basis points instead of the traditional 100 basis points. The Fed is still trying to use all of its tools to free up the illiquidity from subprime problems.
While many still think the Fed will continue to cut interest rates during the rest of 2007, the statement actually takes a neutral stance. Yes, the Fed cut rates coming off an August statement that had an anti-inflation bias – something that is rare. The Fed usually goes to a neutral policy stance and then slow growth/recession risk stance before cutting rates. And now the Fed emphasizes equally “the uncertainty surrounding the economic outlook” and the fact that “some inflation risks remain” – a neutral policy stance now that rates have been cut 50 basis points.
Underscoring the balance posture, the Fed stated:
“Developments in financial markets since the Committee’s last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth. Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.”
While the financial markets are expecting more interest rate cuts this year, the Fed seems to be saying that they will wait and see.
The day after the Fed rate cut, the August CPI fell slightly on lower energy prices, supporting the Fed’s move in the context of inflation being down. The overall consumer price index in August fell 0.1 percent, following a 0.1 percent up tick in July. But there remain inflation concerns. The core CPI inflation rate posted a 0.2 percent increase, after rising 0.2 percent in each of the prior two months. While inflation is modest for now, a key issue is what is going to happen to headline and core numbers when higher oil prices begin to be factored in. Lower energy prices helped the overall CPI in August as they did in July and June but more so in August. Energy prices dropped 3.2 percent, following a 1.0 percent drop in July. Energy weakness was led by motor fuel which fell 4.9 percent.
Year-on-year, the overall CPI declined to 1.9 percent in August from 2.4 percent in July. The core rate stood at 2.1 percent in August, down from 2.2 percent for the prior month on a year-on-year basis. Taking into account that the CPI tends to run about 1/4 percentage point higher than the core PCE price index, this puts the core CPI just within the Fed’s implied inflation target of 1 to 2 percent annualized for the core PCE price index.
As was the case for the CPI, the producer price index slipped in August due to a temporary dip in energy costs but the core actually edged up. The overall PPI fell 1.4 percent in August, following a 0.6 percent spike in July. However, the core rate rose 0.2 percent in August, following a 0.1 percent rise the month before.
The year-on-year rate for the overall PPI dropped to up 2.1 percent in August (seasonally adjusted) from up 3.9 percent in July. The year-on-year core rate came in at 2.2 percent in August, down from 2.4 percent in June.
Housing starts fell 2.6 percent in August to a lower-than-expected 1.331 million unit rate, the lowest rate since June 1995. Permits fell more steeply, down 5.9 percent to a 1.307 million rate, also the lowest rate since June 1995. Year-on-year, housing starts are down 19.1 percent with permits down 24.5 percent. Starts and permits are being depressed by the swollen supply of houses on the market, at 9.6 months for existing homes in July and at 7.5 months for new homes.
The manufacturing sector seems to be holding in moderately positive territory — at least in the New York and Philly Fed regions. Based on the latest reports, manufacturing seems well poised to start taking advantage of the latest decline in the dollar which makes U.S. manufactured goods cheaper overseas. The Empire State index fell back from 25.1 in August to 14.7 in September but this still represents moderate growth. The Philadelphia Fed's business activity index rose to 10.9 in September from a dead-flat 0.0 reading in August. The headline reading along with most components indicate that conditions in the Mid-Atlantic manufacturing region are expanding.
Price readings showed significant cost pressures with the prices paid index up 7 tenths to 35.1, and prices received showing new pressure at 11.7 vs. 3.2. The readings are the first to suggest that $80 oil is leading to a new round of cost increases.
The Fed has cut short-term rates significantly to prevent subprime lending fallout from further impacting the rest of the economy. But there is a big question remaining as to whether the Fed will be able to follow through with the rate cuts expected over the next year by the markets.
As indicated by the fed funds futures market, the immediate reaction (same day) to the rate cut was significant and the implied futures puts the rate at 4 percent by summer of 2008. But after the markets soaked in a few days worth of rising oil prices, a sharply declining dollar, and rising commodity prices, fed funds futures participants scaled back their expectations in 2008 to 4-1/4 percent by mid-year. Within three or four quarters, the Fed may be facing a combination of sluggish economic growth and still too high inflation. This is not likely to be your mother or father’s stagflation of the 1970s but perhaps stagflation lite.
On a final note, whether the Fed needs to maintain the inflation fight or be able to cut rates heavily depends on how current price data impact inflation and the real fed funds rate (nominal fed funds less the inflation rate). The current fed funds target rate is still a little on the tight side IF inflation is really at the 2 percent level. This is seen below comparing real fed funds to the long-term average. Nonetheless, for inflation to continue to ease more than currently, the Fed will have to keep the real fed funds rate a little high. This may delay some of the expected rate cuts.
This coming week gives us some new key data on housing, manufacturing and the consumer sector with existing home sales, durable goods orders, personal income, and consumer sentiment, among others.
Existing home sales held steady in July at an annualized pace of 5.750 million versus 5.760 million in June. July’s rate was the lowest in nearly five years and is down 9.0 percent year-on-year. Given the continuing decline in housing starts, markets will be focusing on whether supply is beginning to come down – which is needed before housing construction can pick back up. The supply number for July was disheartening, coming in at a record 9.6 months. We need both a rise in sales and a decline in supply but it might be October before we see improvement from the Fed’s recent interest rate cut.
Existing home sales Consensus Forecast for August 07: 5.5 million-unit rate
Range: 5.3 to 5.7 million-unit rate
The Conference Board's consumer confidence index fell back to 105.0 in August, down from a cyclical high of 111.9 in July. The decline was roughly evenly split between the leading component of expectations, 88.2 vs. 94.4, and the present situation, 130.3 vs. 138.3. Given the split nature of the economy in September — continuing credit crunch worries early in the month and post-Fed rate cuts later in the month — it is going to be hard to make much sense out of the September report.
Consumer confidence Consensus Forecast for September 07: 104.0
Range: 100.0 to 105.5
Durable goods orders in July rose sharply with gains widespread. Durable goods orders jumped 5.9 percent in July, following a 1.9 percent partial rebound in June. Excluding the volatile transportation component, new orders posted a large gain, rising 3.7 percent in July following a 1.2 percent decline in June. Excluding defense, new durables orders surged 4.9 percent, following a 2.3 percent gain in June. Durables orders are very volatile on a monthly basis – even for the stripped down versions – and a partial reversal of the July numbers should not be a surprise. A negative number that more than offsets July is what would be worrisome.
New orders for durable goods Consensus Forecast for August 07: -3.1 percent
Range: -7.0 percent to +1.0 percent
Initial jobless claims continue to indicate that the labor market is somewhat tight as initial claims for the week ending September 15 fell 9,000 to a level of 311,000. Despite the recent turbulence in the financial markets and fears by some of economic slowing, firms clearly are being slow to lay off workers. But, in contrast, there is not sustained evidence that firms are expanding their work force. Continuing claims for the September 8 week did fall 53,000 to 2.544 million, but the four-week average is still on the high side at 2.577 million.
Jobless Claims Consensus Forecast for 9/22/07: 320,000
Range: 310,000 to 320,000
GDP in the first revision to second quarter data was revised up to an annualized 4.0 percent from the initial estimate of 3.4 percent. The second quarter GDP price index was left unchanged from the initial estimate of 2.7 percent while the core PCE price index was revised to an annualized 1.3 from the initial estimate of 1.4 percent. With the recent disarray in the financial markets and recent and generally softer monthly data, the second quarter GDP numbers are looking like ancient history. But the final numbers do still give us important information on how strong the economy was as it headed into the more turbulent third quarter.
Real GDP Consensus Forecast final Q2 07: +3.8 percent annual rate
Range: +3.6 to +4.0 percent annual rate
GDP price index Consensus Forecast for final Q2 07: +2.7 percent annual rate
Range: +2.7 to +2.7 percent annual rate
New home sales edged higher in July to an annual rate of 870,000, up 2.8 percent from a slightly upward revised June rate of 846,000. But levels remained weak with year-on-year sales down 10.2 percent in the month. As with existing homes for sale, supply is still a problem for new homes but not quite as much. Supply on the market edged back slightly to 7.5 months from 7.7 months. The markets have largely stopped believing the home prices due to the drop in low in sales pushing up the median price. The median price for a new home rose 3.9 percent to $239,500 in July. Year-on-year, the median price is up 0.6 percent.
New home sales Consensus Forecast for August 07: 0.835 million-unit rate
Range: 0.790 million to 0.870 million-unit rate
Personal income growth continued strong in July, posting a 0.5 percent increase, following a 0.4 percent boost in June. But the string of healthy gains is likely to be interrupted in August given the 4,000 decline in payroll jobs for the month and an unchanged workweek. But the 0.3 percent gain in average hourly earnings should keep August’s personal income in positive territory – at least the wages & salaries component. Personal consumption strengthened in July, rising 0.4 percent, following a 0.2 percent increase in June. But more recently, retail sales softened with retail sales excluding autos falling 0.4 percent in August. On the plus side, motor vehicle sales were positive for the month. On the inflation front, the core PCE price index rose 0.1 percent in July, down from June's 0.2 percent increase. But the August core CPI number came in at 0.2 percent, albeit the unrounded core CPI was a little below 0.2 percent. There are probably about 50/50 odds on whether the core PCE price index for August comes in at 0.1 percent or 0.2 percent. The markets will be watching this inflation number to see whether the Fed gets the trend down for core inflation in order to make further interest rate cuts.
Personal income Consensus Forecast for August 07: +0.3 percent
Range: +0.2 to +0.4 percent
Personal consumption expenditures Consensus Forecast for August 07: +0.4 percent
Range: +0.2 to +0.6 percent
Core PCE price index Consensus Forecast for August 07: +0.1 percent
Range: +0.1 to +0.2 percent
The NAPM-Chicago purchasing managers’ index held steady and moderate, rising to 53.8 in August from 53.4 the month before. Low to mid 50 readings for the headline composite index as well as the report's sub-indexes indicate that slightly more purchasers in the area reported month-to-month growth than those reporting contraction. New orders, the most important of the sub-indexes, rose to 58.4 from 53.4, pointing to rising production in the months ahead.
NAPM-Chicago Consensus Forecast for September 07: 52.9
Range: 51.5 to 56.0
The Reuter’s/University of Michigan’s Consumer sentiment index actually improved in mid-September, edging up to 83.8 from August's final reading of 83.4. The assessment of current conditions, an important sub-index for an indication on public reaction to the subprime mess, was little changed at 98.3 vs. 98.4 in August. Given that confidence means much for maintaining consumer spending, the markets will be watching to see if the consumer sector has put much of the financial turbulence of August behind it and whether the Fed’s interest rate cut is boosting confidence. However, it may be October before we see the full impact.
Consumer sentiment Consensus Forecast for final September 07: 84.3
Range: 82.7 to 85.0
Construction spending declined 0.4 percent in July, following a revised 0.1 percent rise in June. But recent sector trends continue with the residential component declining and other major components continuing upward trends. Private residential construction fell 1.4 percent in July, while public outlays and private nonresidential construction rose 0.7 percent and 0.4 percent, respectively.
Construction spending Consensus Forecast for August 07: -0.5 percent
Range: -0.7 to +0.2 percent
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