Upside down you’re turning me Econoday Simply Economics 6/5/00 By Evelina M. Tainer, Chief Economist

If it’s Tuesday it must be Belgium
Stock market fluctuations have become cliché. Weeks in which bearish news creates down markets are usually followed by weeks where news is bullish and markets rally. The sad part about volatility is that it often takes little to move markets drastically in one direction or another. Views about economic fundamentals shift 180 degrees -- either the Fed will raise rates continuously through the summer or the Fed has completed its tightening cycle. The market volatility of the past few weeks has really underscored the fact that investing for the long term is the best bet.

Despite the rally in the NASDAQ composite this past week, the Russell 2000 is the leading stock market index with respect to gains since year-end (+1.6%) followed closely by the S&P 500 (0.5 percent). The Dow Jones Industrials are 6.2 percent below year-end, and the NASDAQ composite is 6.3 percent below year-end levels.

Favorable economic news triggers bond rally
Last week, some of the rally in the bond market was due to the fact that investors were leaving stocks in droves and wanted a safe-have opportunity. This past week, bond yields fell because economic news was uniformly below expectations. It is too soon to call it an official slowdown in economic activity, but the data certainly will give the Fed room for pause. Market players aren’t convinced that the Fed has completed its tightening cycle yet, though most believe the end is in sight.

Markets at a Glance
Treasury Securities	12/31/99	May 26	June 2	Weekly Change
30-year Bond	6.48%	6.06%	5.94%	- 12 BP
10-year Note	6.43%	6.33%	6.15%	- 18 BP
5-year Note	6.34%	6.57%	6.37%	- 20 BP
2-year Note	6.24%	6.67%	6.50%	- 17 BP
Stock Prices
DJIA	11497*	10303*	10779*	+ 4.6 %
S&P 500	1469*	1378*	1477*	+ 7.2 %
NASDAQ Composite	4069*	3205*	3814*	+19.0 %
Russell 2000	505*	457*	513*	+12.3 %
Exchange Rates
Euro/$	1.0008	0.9311	0.9441	+ 1.4 %
Yen/$	102.40	106.96	108.14	+ 1.1%
Commodity Prices
Crude Oil ($/barrel)	$25.60	$29.90	$30.30	+ 1.3 %
Gold ($/ounce)	$289.60	$272.00	$284.50	+ 4.6 %
(BP = basis points; stock price indices are rounded)

Underlying employment falls, market gets happy
Nonfarm payroll employment grew 231,000 in May after posting gains more than twice as large in the previous two months. As usual, the headline figure is misleading, because the Census added 357,000 temporary workers to its payrolls. This means that private payrolls declined for the first time in four years. Temporary workers at the Census have added to payrolls since January. Eventually, these workers will come off the payrolls over the next several months and depress employment gains. The chart below depicts the actual monthly change in nonfarm payrolls along with the three-month moving average of the series, excluding Census workers. It turns out that the average has remained in the same range over the past several months with the three-month moving average back to the lowest level since October 1999 at 208,000.

Can we trust the payroll data to tell us that employment demand is indeed cooling off? We should know better than to take one month’s data at face value. Also, declines in payrolls weren’t concentrated in any particular category but evident across the board. Usually, that suggests less-than-ideal seasonal adjustment factors. Moreover, one can’t know for sure if May weakness stems from March and April strength or June data will reverse course once again.

The civilian unemployment rate edged back up to 4.1 percent in May after briefly dipping to 3.9 percent last month. Both the labor force and employment decreased for the month. The pool of available workers increased 310,000 in May, reversing about three-quarters of last month’s drop. Nonetheless, on the longer term trend Greenspan’s favorite labor market indicator still shows that the labor pool is in shrinking mode.

Hourly earnings inched up 0.1 percent in May after posting stronger gains in the past several months. As a result, the yearly rise of 3.5 percent is lower than the previous three months. It’s too soon to say that the upward trend in wages has reversed. Nevertheless, it does suggest that wage pressures are not accelerating rapidly at this point.

The bottom-line on the employment situation? Every major component in the employment situation pointed in the same direction – slower economic growth with less wage pressure. One month does not make a trend – and no one knows that better than the Federal Reserve. Yet, the employment report typically sets the tone for the economic indicators that are released over the course of the month. Given the weaker tone to the May employment figures, it is possible that most incoming data will be soggier. This will make it more difficult for the Fed to raise rates aggressively at the June FOMC meeting. Indeed, the employment situation may convince investors that the Fed won’t change rates at all this month. The most likely scenario will see a 25 basis point rate hike.

Interest rates dampen housing and motor vehicles
Sales of new single family homes declined 5.8 percent in April to a 909,000-unit rate. There is no question that the level of housing demand remains relatively healthy by historical standards, but sales seem to have peaked nearly a year ago. The same pattern was exhibited by existing home sales as well.

The chart above reveals that mortgage rates have continued their upward climb just as the Fed has raised rates over the past year. In May, the 30-year mortgage rate averaged just over 8.5 percent. The last time mortgage rates were at this level home sales were weaker, but strong income growth helped spur demand for housing. If mortgage rates head higher, it is likely that housing will cool down further in coming months.

Consumer confidence surged in May despite the fact that the Fed raised interest rates and stock markets fluctuated wildly during the month. It simply reflects the fact that a healthy labor market fuels optimism more than any other indicator. Despite the surge in confidence, though, motor vehicle sales drifted lower yet again in May. Both car and truck sales peaked in February. The level of motor vehicle sales, just like home sales, remains robust by historical standards. Yet, the downward direction in sales signals declines in consumer durables in second quarter GDP. This should dampen the overall growth rate for the period.

The bottom-line on the consumer sector? Although the level of home sales remains high, the downward drift in housing means that this sector will be less likely to contribute to GDP growth in the second quarter. Eventually, softer home sales also translate into less demand for durable goods such as furniture and appliances. The Fed will have to be encouraged that higher mortgage rates are finally affecting the housing market. Historically, this is the mechanism by which the Fed cools down the economy: interest-sensitive sectors moderate first and eventually consumer spending slows as well.

Manufacturing growing…at slower pace
The NAPM survey suggests that manufacturing activity may start slowing down. The composite index fell back to 53.2 in May, its lowest level in more than one year. As long as the index remains above the 50 percent mark, though, it still reflects increases in the manufacturing sector.

The prices paid index has declined roughly 10 points over the past two months. This could be reflecting somewhat softer oil prices from their highs. But the fact remains that the level of this index is still pointing to rising prices – as long as the index stays above the 50 percent mark. The index is moving in the right direction, but it remains to be seen whether it will continue to head lower in coming months.

THE BOTTOM LINE
The Federal Reserve will have a lot to ponder at the June 27 & 28 FOMC meeting. In the past couple of weeks, several economic indicators have not only come in below expectations, but some are trending lower. Reading too much into one month’s data is foolish, but at least Fed officials now have signs that some of the rate hikes of the past year may indeed be hampering consumer demand.

Bond and equity investors believe they see the end of the tightening cycle. Market players are probably pricing in one more 25 basis point rate hike for June or August. Yet, the rally in the bond and stock markets clearly suggests that investors see better days ahead.

More than three weeks will elapse before the next FOMC meeting. During this time, several key indicators will be reported, including retail sales and consumer prices, which could shift market sentiment once again. The Fed need not make any decisions until June 28. Most likely, the best bet is to expect stock and bond prices to fluctuate sharply over this time period.

Looking Ahead: Week of June 5 to June 9
Market News International compiles this market consensus which surveys about 20 economists each week.

Tuesday
Economists are predicting the Labor Department will leave unrevised first quarter nonfarm productivity at a 2.4 percent rate. At the same time, unit labor costs are expected to remain unchanged also at a 1.8 percent rate.

Wednesday

The market consensus is looking for a sharp moderation in consumer installment credit – growing $7 billion in April, not quite half the pace recorded in February and March.

Thursday
Market participants are expecting new jobless claims to edge down 1,000 in the week ended June 3 from last week's 286,000 level.

Friday
Market players are looking for an increase of 0.3 percent in May’s producer price index. This reflects only a modest gain in energy prices. Excluding food and energy, the PPI is expected to edge up 0.1 percent, the same as the past several months.

Looking Ahead to the Week of June 12
The preliminary consensus shows retail sales are expected to inch up 0.1 percent in May, slower than the 0.6 percent gain posted in April. Retail sales excluding the auto group should rise 0.3 percent, also less than the previous month when nonauto retail sales grew 0.5 percent.

Initial estimates show that economists are predicting the consumer price index will rise 0.2 percent in May, higher than April’s unchanged figure. Excluding food and energy prices, the CPI is also expected to increase 0.2 percent, the same as last month.

Economists are predicting the index of industrial production will decrease 0.5 percent in May, reversing about half of the previous month’s gain. This is based on the drop in hours-worked in manufacturing as indicated by the employment situation. As a consequence, the capacity utilization rate should edge back down to 81.5 percent after surpassing the 82 percent level last month.