Dog days of summer bring mixed news Econoday Simply Economics 8/31/00 By Evelina M. Tainer, Chief Economist

Stock prices surge at month end
Stock markets rallied on Thursday, the last day of the month, in part on news that factory orders plunged in July. This created expectations that the Fed may no longer need to raise rates in this cycle. The funny part of this explanation is that the drop in factory orders was exactly in line with expectations - and was due to a plunge in defense and aircraft orders, typically volatile sectors. It is likely that some of the euphoric sentiment came from thin summer markets in anticipation of the Labor Day holiday.

The chart below shows that despite the August 31 rally, stock market indices are not doing very well relative to year-end. In the eighth month of this year, levels are only marginally higher than they were on December 31, 1999 (Note that the Dow Jones Industrials are not quite yet back to Dec. 31 levels.) Of course, one should keep in mind that the gains over the past years can't be duplicated indefinitely, and reverting to the long term average can mean a couple of years of sluggish activity. But modest stock appreciation would mollify the Fed, as they believe consumer spending is coming from the "wealth effect." If consumers don't see continuous increases in their wealth, then consumer spending will be more in line with income.

Treasury yields drop at intermediate end
Treasury yields remained in the tight range of the past several weeks. Yields have ticked higher in the past week, but a sharp drop in factory orders helped spur a rally in the bond market today - even ahead of the employment data. Yields fell dramatically across the yield curve from yesterday, but are down only marginally from last Friday. Most of the activity took place at the intermediate end of the curve (the 2-year and 5-year notes).

The chart below depicts the yield curve at month end and compares it with the month end in June. Note the dramatic decline in yields across the curve. Only the 3-month bill yield is higher - reflecting the higher federal funds rate. The long end of the curve (the 10-year and 30-year yields) reflects supply issues, but the intermediate end (2-year and 5-year) may reflect an expectation on the part of market players that the Fed has completed its tightening cycle. This means the next move could be in a downward direction.

Oil prices above $30 in August
Oil prices moderated through July after OPEC oil producers indicated that they would pump out more oil. Yet supplies remain tight in the United States and prices headed back up over the $30 mark. Indeed, oil prices (West Texas crude futures) surpassed $33 the last two days of the month to reach their highest level since March 7 when crude oil futures prices closed at $34.05. If these price levels are sustained in the next several weeks, it will be another run-up in gasoline prices - measured in the producer and consumer price indices. It won't be a pretty sight.

Markets at a Glance
Treasury Securities	12/31/99	2000 High	2000 Low	25-Aug	31-Aug	Week % Change
30-year Bond	6.48%	6.75%	5.70%	5.67%	5.67%	0.00%
10-year Note	6.43%	6.77%	5.78%	5.72%	5.73%	0.01%
5-year Note	6.34%	6.81%	6.01%	6.00%	5.97%	-0.03%
2-year Note	6.24%	6.90%	6.13%	6.18%	6.16%	-0.02%
Fed Funds Rate Target	5.50%	6.50%	5.50%	6.50%	6.50%	0.00%
Stock Prices
DJIA	11497	11723	9811	11193	11215	0.2%
S&P 500	1469	1524	1348	1506	1518	0.7%
NASDAQ Composite	4069	5049	3164	4043	4206	4.0%
Russell 2000	505	606	457	525	538	2.4%
Wilshier 5000	13813	14751	12475	14091	14279	1.3%
Exchange Rates
Euro/$	1.0008	0.8893	1.0336	0.9020	0.8880	-1.6%
Yen/$	102.40	111.35	101.45	107.04	106.65	-0.4%
Commodity Prices
Crude Oil ($/barrel)	$25.60	$34.05	$21.20	$32.05	$33.10	3.3%
Gold ($/ounce)	$289.60	$326.00	$273.90	$278.70	$282.20	1.3%

Manufacturing activity slows
Factory orders plunged 7.5 percent in July reflecting a sharp reversal of defense orders (mostly aircraft). While the drop seems ominous, it does follow two strong monthly gains that added up to a 9.7 percent rise. Durable and nondurable goods orders do show monthly volatility. Consequently, it is useful to look at a three (or more) month trend in various components to see if the weakness is pervasive. As it turns out, some of the durable goods categories are sluggish (fabricated metal products, primary metals) while others are just exhibiting their normal patterns (industrial machinery, electronic and electrical equipment, transportation).

The chart below looks at the quarterly changes in new orders on a year over year basis. After a surge in the second quarter, the third quarter is bound to moderate at least somewhat. Keep in mind, though, that for the moment the third quarter consists of only July data. As usual, information technology equipment fares better than other goods.

The bottom-line on manufacturing? New orders did plunge in July - perhaps suggesting that manufacturing activity may soften in the next few months. However, these figures fluctuate dramatically from one month to the next. A broader perspective reveals that activity was still rising smartly from year ago levels. The Chicago purchasing managers' index revealed that manufacturing activity moderated in the Midwest - and could be signaling a moderation in manufacturing activity nationwide. However, it is premature to suggest that manufacturing is faltering altogether.

Consumers: optimistic and at full force
Sales of new single family homes surged 14.7 percent in July, more than reversing the previous month's drop and at 944,000, were slightly ahead of year ago levels. Sales did not surpass the previous peak set in June 1999. Yet it is more relevant to consider total home sales, not just new homes, which are a small portion of the total market. Note that the trend remains consistently downward - even though mortgage rates have come down from their highs (8.5 percent) reached a couple of months ago. The monthly variability has been more dramatic in the past year than the clear upward trend exhibited from 1996 through mid-1999. This has to be a signal that housing activity has already peaked.

Consumer spending outstripped income in July leading to another dip in the personal savings rate. Income edged up 0.3 percent while consumption expenditures rose 0.4 percent. As a result, the savings rate fell back to -0.2 percent. The chart below shows that the disparity between annual real income and consumption growth simply refuses to narrow. This reflects the high degree of confidence consumers have in their job prospects as well as the leftover euphoria over the accelerated pace of stock market wealth. We refer to "leftover euphoria" because stock prices have not accelerated in 2000 the way they had in the previous few years. Thus, the "wealth effect" should eventually wane as a factor contributing to consumer spending growth.

The bottom-line on the consumer sector? The spurt in new home sales coupled with the plunge in existing home sales for the month of July suggest that housing activity is still percolating, but not accelerating from the pace of the past several months. Eventually, the lower pace of housing activity filters through to the durable goods market - although one would never know it by the continued strong pace of consumer spending. The negative savings rate reflects a high degree of consumer confidence (as do the Conference Board numbers) but suggests that consumers don't have a big cushion to fall back on in case of hard economic times.

THE BOTTOM LINE
In the week since Fed officials convened to determine monetary policy, economic indicators are pretty much suggesting that they made the right decision at the August 22 meeting. Economic news is somewhat mixed - plunging existing home sales, surging new home sales, plunging factory orders, healthy income and consumption growth. But a mixed data bag does indicate that the economy is still active and not falling into recession. After all, Fed officials are trying to engineer a soft landing, not a crash.