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The Fed cut interest rates by half a percentage point this past Wednesday. But heading into the meeting, it was not entirely certain that the Fed would follow through as durables orders surged in December and inflation was still strong. But by week end, payroll employment fell for the first time in over four years and it appeared the Fed made the right move to take out more anti-recession insurance.
Last week the Fed cut interest rates by half a percentage point on Wednesday afternoon. Curiously, that was the only day of the week that equities did not show their gratitude. But for the week net, major indexes showed smart gains and made it a two-week winning streak for most indexes. And despite signs of recession at week end, the largest quarterly and yearly profits in history for a U.S. company were reported on the same day.
Last week, the equity markets had a hard time deciding whether bad news was good news and whether good news was good news. The week started with a gain in equities on Monday as the morning’s abysmal report on new home sales was seen as keeping the Fed on track to keep cutting interest rates. On Tuesday, good news was good news as the markets liked the reported surge in durables orders, which muted recession talk – at least for the day. Stocks fell on the news of the 50 basis point cut in interest rates by the Fed on Wednesday afternoon. The Fed action met expectations and some profit taking set in. Also, rumors that a major bond insurer would be downgraded weighed on the markets. While there were good company reports from Boeing and Altria, negative news from Yahoo!, Merck, and UBS helped tug equities down for the day. Stocks were led upward Thursday largely on news that the world’s largest bond insurer, MBIA, expected to retain its AAA credit rating. Stocks even rose on Friday despite the first decline in payroll jobs in over four years. M&A was on traders’ minds as Microsoft made a bid to buy Yahoo! in order to compete with Google. Exxon also announced the largest ever quarterly and annual profits for a U.S. company as higher oil prices boosted the company’s bottom line.
While January was either the worst month ever or close to it for many indexes, the past week did help partially reverse the month's losses. For the week, small caps led the way as is typical during a period of interest rate cuts. Small caps are more interest rate sensitive.
Last week, major indexes were up: the Dow, up 4.4 percent; the S&P 500, up 4.9 percent; the Nasdaq, up 3.7 percent; and the Russell 2000, up 6.1 percent.
January was not a good month with all major indexes falling significantly. The Nasdaq had its largest one month loss ever and the S&P 500 just missed setting a similar record.
Since year end, major equity indexes are still in negative territory. Major indexes are down as follows: the Dow, down 3.9 percent; the S&P 500, down 5.0 percent; the Nasdaq, down 9.0 percent; and the Russell 2000, down 4.6 percent.
Treasury yields were mixed last week as short rates fell and yields on the long end firmed. Rates drifted higher on Monday and Tuesday as some funds flowed into rising equities and a strong durable goods report caused greater doubt that the Fed would ease a full 50 basis points on Wednesday afternoon. Short term rates fell moderately on Wednesday with the Fed’s rate cut leading the way. Rates eased further on Thursday as initial unemployment claims spiked sharply and consumer spending came in soft in the personal income report. Long bond rates eased a little on Friday on flight to safety over concern about bond insurers being downgraded. A moderate gain in equities helped to slow the flight to safety, however. The bottom line is that the yield curve continued to steepen with a drop in near end yields being the primary reason. This bodes well for economic growth in coming months.
Treasury yields were mixed in direction last week follows: 3-month T-bill, down 17 basis points, the 2-year note; down 10 basis points; the 5-year note, down 1 basis point; the 10-year bond, up 4 basis points; and the 30-year bond, up 5 basis points.
Since year end, the 2-year T-note has fallen 98 basis points while the 10-year T-note declined 44 basis points. The 3-month T-bill is down a sharp 116 basis points since December 31.
Oil prices rose early during the past week but fell during the latter two days on strong signs of a slowing in the U.S. economy. Early in the week, strong durables and the Fed’s 50 basis point cut nudged the spot price for West Texas Intermediate to the week’s high at $92.33 per barrel. Also supporting prices were expectations that OPEC would leave production quotas unchanged at its meeting later in the week and a temporary shutdown in a Canadian production facility. Prices slipped on Thursday’s spike in initial claims but dropped $1.43 on the last day of the week over recession fears induced by the 17,000 decline in January payroll employment. Fears of slower economic growth clearly are weighing on oil prices.
The spot price for West Texas Intermediate fell $2.79 per barrel net for the week to settle at $88.96 per barrel, $10.66 below the record high of $99.62 set January 2nd.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
This past week the financial markets had to absorb a lot of economic data with significant surprises both on the upside and downside. While many are pointing to a drop in employment as the start of recession, others see an upsurge in durables orders suggesting that the economy is already starting to improve. The truth likely is in between – that the economy is still in a soft spot – as anticipated by Fed officials several months ago.
January’s jobs report came in negative, pointing to the start of a soft first quarter. Payroll employment in January surprisingly fell for the first time in over four years. Nonfarm payroll employment fell 17,000, following revised increases of 82,000 in December and 60,000 in November. For December and November combined, the net revision was up 21,000.
As usual in recent months, within the payroll survey weakness was in the goods-producing sectors. Manufacturing fell by 28,000 in January, following a 20,000 drop in December. Construction jobs decreased 27,000 in January after a 45,000 decline the previous month. Natural resources & mining rose by 4,000 in December.
The service-providing sector was positive but nonetheless slowed dramatically, rising a modest 34,000, following a 143,000 gain in December. Even in this sector there was not much good news. The latest month was led by education & health services, up 47,000, and by leisure & hospitality, up 19,000. Declines were led by government (mainly state government education), down 18,000, and by professional & business services, down 11,000.
Some good news out of the report is that wage inflation eased. Average hourly earnings posted a 0.2 percent gain in January, following a 0.4 percent rise the prior month. On a year-on-year basis, average hourly earnings held steady at 3.7 percent in January but are down moderately from the cycle high of 4.3 percent set in December 2006.
Turning to the household survey, the civilian unemployment rate edged back down to 4.9 percent from 5.0 percent in December and matched the consensus forecast for a dip to 4.9 percent. The household survey is much smaller than the payroll survey and the employment numbers are more volatile than the payroll numbers.
Does the January decline in payroll jobs mean the economy is in recession? Maybe – maybe not. Recessions are heavily determined by several indicators, including payroll employment, real personal income, business sales, and industrial production which make up the Conference Board’s index of coincident indicators. There has yet to been a consistent downward trend in these coincident indicators. Also, economists generally do not state that the economy is in recession until there has been an extended period of negative growth – at least six months and the Fed's aggressive rate cuts may kick in soon enough to preclude that.
But there are two technical issues that should be kept in mind about January’s dip in employment. First, it is very difficult to seasonal adjust employment before and after holiday periods-including January. Second, we have already seen an initial estimate of a 4,000 decline for August 2007 being revised back into positive territory. There is no doubt that the economy has slowed sharply – but it is not clear that it has turned negative.
According to the first estimate for fourth quarter GDP, the economy narrowly escaped turning negative at year end even though inflation picked up significantly. Fourth quarter real GDP eased to an annualized 0.6 percent, following a robust 4.9 percent surge in the third quarter. The deceleration in fourth quarter growth was due to a slowing in growth of personal consumption spending, business fixed investment, government purchases, a worsening in residential investment, and a decline in business inventories. Net exports actually improved despite a slowing in export growth as real imports growth slowed sharply. While the numbers were slower, personal consumption of durables and also business fixed investment were still moderately healthy, especially for structures. It should be noted that much of the softness in was in inventories. Real final sales held up at a stronger pace, rising a annualized 1.9 percent, following a 4.0 percent surge in the fourth quarter.
Higher oil prices led to a jump in the GDP price index to an annualized 2.6 percent, following a 1.0 percent rise in the third quarter. The Fed in recent months indicated that it cares about overall PCE inflation as much as core and the latest numbers should be worrisome. The overall PCE price index jumped to an annualized 3.9 percent from 1.8 percent in the third quarter. The core PCE price index also quickened but not as much, rising an annualized 2.7 percent in the fourth quarter, after increasing 2.0 percent the prior quarter.
Despite another healthy gain in personal income, there are signs that the consumer is tapping the brakes on spending. Personal income in December rose 0.5 percent, following a 0.4 percent boost in November. Within personal income, the all important wages and salaries component advanced 0.4 percent, following a 0.6 percent increase in November. As long as wage & salary income is continuing to rise, consumers will keep spending and likely keep the economy out of recession.
On the spending side, the economy may be getting some serious softening as consumer spending slowed to a 0.2 percent rise after November's sharp 1.0 surge. But taking into account how strong November was, the December deceleration is not a surprise.
Although the Fed has been cutting interest rates, there still are signs that inflation remains too high. The overall PCE price index increased 0.2 percent in December, after surging 0.6 percent in November. The core PCE price index held steady at 0.2 percent in December but the core measure has been on the high side of 0.2 percent for the last three months. Year-on-year headline inflation edged down slightly but clearly is too strong for the Fed's preferences, slipping to 3.5 percent in December from 3.6 percent in November. Core inflation held steady at 2.2 percent year-on-year in December. Both series are above the Fed’s implicit inflation target zone of 1-1/2 to 2 percent.
While the employment report got more of the markets’ attention, the biggest negative of the past week may have been another drop in new homes sales, down 4.7 percent in December after a 12.6 percent drop the prior month. The housing market recession appears to be depending. New home sales were down 41 percent for the year. December’s annual unit rate of 604,000 is the lowest rate in 12 years. Supply rose to 9.6 months, up from 9.4 months in November and the worst reading in 27 years.
Price depreciation appears now to be accelerating, down 10.9 percent in December alone to $219,200 for a 10.4 percent year-on-year decline.
Early in the past week, the durable goods report briefly had the markets forgetting about the “R” word. Durable goods orders surged 5.2 percent in December, following a 0.5 percent rise in November. While December's jump in orders was led by aircraft, strength was notable in many components. Even excluding the transportation component, new orders advanced a robust 2.6 percent in December, following a 0.4 percent fall in November. Durables should nudge manufacturing back into positive territory in coming months – especially if lower interest rates boost business investment in equipment and accelerate consumer spending on motor vehicles.
Another positive this past week for manufacturing was the January ISM report. Led by a gain in production, the Institute For Supply Management's manufacturing index edged back over the 50 level to 50.7, up 2.3 points from December. Production jumped nearly 7 points to 55.2 in January, a good start to the manufacturing year. Both the durables report and ISM report suggest that the economy may avoid recession.
Last week the Fed cut interest rates by another 50 basis points even though earlier in the week, new factory orders for durables had surged. There is a good chance that at least some of the FOMC members had been given some kind of private warning about the January jobs report by the Labor Department. The fed funds target rate is now 3.0 percent and the discount rate is now 3.5 percent. The Fed stated that the reasons for the cuts included "considerable stress" remaining in financial markets, deepening weakness in housing, and a softening in the labor market. The FOMC noted that "downside risks remain." There was one dissenting vote – Richard Fisher, the Dallas Fed president who wanted no change in rates. The fed funds target rate is at its lowest since June 29, 2005, the day before the Fed raised the target to 3.25 percent.
The key paragraph explaining the Fed rate cuts is:
"Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets."
The latest FOMC statement clearly shows the Fed choosing to take out more anti-recession insurance and the lower rates should begun impacting consumer spending and business investment. In doing so, the Fed still must be concerned about potential inflation. Currently, the Fed "expects inflation to moderate in coming quarters" and if inflation numbers do not come down in coming months, the Fed will have to consider when to raise rates. But for now, the emphasis apparently is on anti-recession insurance.
The Fed's next policy meeting is scheduled for March 18. How much further is the Fed likely to cut and how long might the Fed keep rates down before raising rates?
Over the last twenty years U-turns in Fed rate policy have not been uncommon. After the 2001 recession and weak recovery, the Fed cut the fed funds target to 2 percent on June 25, 2003 and kept it there 12 months before starting 17 consecutive rate increases on June 30, 2004.
After the 1990-91 recession, the fed funds target rate hit bottom at 3 percent on July 2, 1992 and lasted 10 months before the next round of tightening started on May 17, 1994.
In each of these prior bottoms in rates, the PCE inflation rate was much lower than currently, 3.1 percent year-on-year in July 1992 and 1.8 percent in June 2003, compared to 3.6 percent for December 2007. The Fed is forecasting inflation to come down but inflation’s current pace compared to the Fed’s target of 1-1/2 to 2 percent indicates that the Fed may not wait as long as in the past to start a U-turn.
According to the fed funds futures market, traders believe the Fed will cut the fed funds target rate to 2-1/2 percent by May and to 2-1/4 percent by August and keep it there for the rest of 2008 and into January 2009. By recent historical standards, keeping the low in the fed funds level for at least half a year is plausible. But taking into account the relatively higher inflation, the rate change pause is not likely to last as long as the 10 to 12 months of the prior two rate cycles.
The Fed’s job is to focus on the medium term for the economy with low and stable inflation providing the foundation for economic and job growth. The Fed continues to cite its concern about inflation and likely is cutting rates just long enough for credit markets to stabilize. Markets consistently underestimated the Fed’s inflation concerns during the last round of rate hikes ending in 2006. Markets are likely underestimating inflation pressures again during the current round of rate cuts.
The economy might be entering a mild recession – with emphasis on “might.” But the data have not all been pointing down – manufacturing appears to improving. But importantly, the Fed’s 225 basis point slashing of the fed funds target rate since August will be kicking in shortly. The economy likely will be soft early in 2008 but should be back on a moderately strong growth path by the latter part of this year. In the mean time, the Fed will be watching to see if its forecast for an easing in inflation actually happens and will be thinking about when to start the U-turn in rates back up.
This coming week there are no major market movers. But with last week’s dip in employment, the jobless claims report on Thursday may get more attention than usual.
Factory orders jumped 1.5 percent in November but the gain reflected a 3.0 percent spike in orders for nondurable goods, a category bloated by price related gains for energy products. But more recently, durables orders have been robust with widespread strength. Durable goods orders surged 5.2 percent in December, following a 0.5 percent rise in November. While December's jump in orders was led by aircraft, strength was notable in many components. Even excluding the transportation component, new orders advanced a robust 2.6 percent in December, following a 0.4 percent fall in November.
Factory orders Consensus Forecast for December 07: +2.3 percent
Range: +0.6 to +3.5 percent
The business activity index from the ISM non-manufacturing survey was mostly steady and moderately healthy in December though it did slip to 53.9 from 54.1 in November. December’s orders numbers point to another healthy number for January. New orders in December rebounded from a dip in the prior month to show a respectable 53.5 level.
Business activity index Consensus Forecast for January 08: 53.0
Range: 51.0 to 54.0
Nonfarm productivity and labor costs in the third quarter were highly favorable for low inflation but that is likely to change in the fourth quarter. Third quarter productivity rose an annualized 6.3 percent increase, following a 2.2 percent gain in the second quarter. Unit labor costs dropped 2.0 percent annualized in the third quarter, following a 1.1 percent decline in the second quarter. But the anemic 0.6 percent annualized rise in real GDP for the fourth quarter points to a significant reversal of the third quarter productivity and unit labor cost numbers – many of the GDP source data are also used for productivity and unit labor costs.
Nonfarm Productivity Consensus Forecast for initial Q4 07: +0.5 percent
Range: -0.6 to +2.3 percent
Unit Labor Costs Consensus Forecast for initial Q4 07: +3.0 percent rate
Range: +2.5 to +4.5 percent rate
Initial jobless claims surged in the latest period due to a holiday shortened reporting week. Initial claims soared 69,000 to 375,000 for the week ending January 26 -- the worst level in more than two years. Difficulty seasonally adjusting the week which included the Martin Luther King holiday (Monday, January 21) resulted in the huge spike. The surge followed very low initial claims in recent weeks. But after the dip in payroll employment for January, the question is whether the latest numbers reflect the technical difficulties of seasonally adjusting during winter and holiday months or reflect true weakness. Markets will be watching to see if claims return to prior levels or whether they stay high pointing to possible recession.
Jobless Claims Consensus Forecast for 2/2/08: 343,000
Range: 330,000 to 360,000
Consumer credit jumped $15.5 billion in November, following a modest $2.0 billion rise in October. Consumers turned to their credit cards as revolving credit jumped $8.8 billion vs. an already bloated $6.6 billion gain in October. Markets will be sifting through the detail to see if consumers are relying on credit cards to pay monthly expenses or whether consumers are making rational long-term purchases such as for motor vehicles.
Consumer credit Consensus Forecast for December 07: +$7.4 billion
Range: $4.0 billion to +$12.0 billion
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