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The Fed’s surprise interest rate decision and good news on inflation were completely forgotten in the wake of Fed and Treasury actions to create credit market liquidity and to assure investors that their money was safe. Meanwhile, equities rode the wildest roller coaster on earth and the Treasury sold 3-month bills at essentially a zero interest rate.
It was an even busier than usual week for the Fed and Treasury – and that says a lot given how busy recent weeks have been. The markets this past week cannot be understood without some knowledge of Fed and Treasury actions.
Over the prior weekend, the focus of financial markets was whether Lehman Brothers would be bailed out by private investors (foreign or otherwise), whether the Fed or Treasury would create some recapitalization plan for Lehman Brothers (if found to be “too big to fail”), or whether Lehman Brothers would file bankruptcy. As the weekend concluded, it became apparent that private investors were unwilling to buy Lehman Brothers without substantial help from the government – and a late Sunday night announcement by the Fed indicated that help was not coming, at least not for Lehman Brothers. Also, markets were increasingly worried about the viability of bond insurer American International Group.
Apparently anticipating further tightening in credit markets with a Lehman Brothers bankruptcy, the Fed announced late Sunday night the expansion of its Primary Dealer Credit Facility (PDCF) which now accepts investment grade equities as collateral. Previously, PDCF collateral had been limited to investment-grade debt securities. The Fed also doubled Schedule 2 Term Securities Lending Facility auctions from once every two weeks to once a week. The actions were made necessary by a near seizing of credit over the weekend as banks and others were reluctant to lend, fearing loss of principal if other financial institutions failed.
On Monday, the Fed and the Treasury were encouraging Goldman Sachs and JP Morgan to extend $75 billion in credit to bond insurer AIG. But the investment houses concluded that they were unable to do so without government assistance and assurances. Market uncertainty and unwillingness to lend drove the fed funds rate up to 6 percent on Monday – substantially above the Fed’s target rate of 2 percent.
At this past Tuesday’s FOMC meeting, the Fed left the fed funds target rate unchanged at 2 percent, leaving many market participants disappointed (more on the decision below). The Fed was focusing more on increasing liquidity rather than lowering rates. At the time of the 2:15 EDT announcement, the Fed already had another liquidity boost in the works.
Late that Tuesday night, the Federal Reserve Board announced that the New York Fed had been authorized to lend up to $85 billion to the American International Group (AIG). The loan is intended to "assist AIG in meeting its obligations as they come due." The Federal Reserve Board took this action after private sector efforts to bolster AIG fell through completely. Potential white knights indicated that government assistance was a necessity. AIG is expected to repay the loan by selling certain of its businesses. The Fed will receive a 79.9 percent equity interest in AIG and can veto the payment of dividends to common and preferred shareholders.
Tuesday night’s move by the Fed was critical. AIG is the primary insurer of bonds. The failure of AIG would have resulted in the bonds they insure becoming very illiquid and some issues would have become almost untradeable. The questions of why and how could such a situation develop remain, but it was essential that AIG not fail. Not ripple effects, but tsunamis would have hit other countries as bonds insured by AIG are held overseas, including by sovereign wealth funds. AIG’s losses were not caused by its traditional insurance divisions (which are sound with funds in separate state supervised accounts, leaving insurance holders not at risk). AIG's losses heavily came from defaults on subprime mortgages.
But on Wednesday, credit markets were still very illiquid and the Treasury responded by announcing a special $40 billion 35-day cash management bill auction to add liquidity. Demand for cash equivalents was so extraordinarily high that the low rate during that day's bidding was next to zero percent. Bill rates were at their lowest levels since the early 1950s.
Despite the Fed and Treasury actions through Wednesday, credit was still tight and dollars were in extremely short supply overseas on flight to safety and over reluctance to lend. On Wednesday, demand for U.S. Treasuries was so high that the 3-month T-bill closed at 0.04 percent.
The Fed responded at 3:00 a.m. EDT Thursday ahead of market open in Europe. The Fed increased foreign central banks' access to dollar assets for them to meet liquidity needs by authorizing a $180 billion expansion of its temporary reciprocal currency arrangements (swap lines). This increased capacity was made available to provide dollar funding for both term and overnight liquidity operations by the other central banks. Under the plan, the participating central banks can access funds and inject: Bank of Canada up to $10 billion; the European Central Bank, up to $110 billion; the Swiss National Bank, up to $27 billion; the Bank of Japan up to $60 billion; and the Bank of England, up to $40 billion. The move improved liquidity somewhat.
Early Friday morning, both the Fed and Treasury announced several additional measures to improve liquidity and to assure the public about the safety of their funds.
The Fed said it is extending primary credit loans to banks to purchase asset backed commercial paper (ABCP) from money market mutual funds, in turn helping the funds to meet redemptions and boosting liquidity in the ABCP and broader money markets. The Fed said it will also purchase short-term federal agency notes from primary dealers in a series of auctions over the next several weeks. These are intended to be for short-term debt obligations issued by Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. The Friday moves by the Fed will give critical assistance to two markets that have substantial liquidity problems – ABCP and mortgage backed securities.
The Treasury announced it will provide up to $50 billion of insurance to eligible money market funds to protect investor principal. Many investors in these funds were starting to worry whether they should get out their investments, in effect threatening a run on money market funds. Stock market losses earlier in the week had pushed down the value of assets at Primary Fund to 97 cents per dollar invested. The Treasury’s action takes away much incentive for a run on mutual funds. A rebound in equities on Friday also helped.
Finally, the Treasury – in consultation with the Fed, Congressional leadership of both parties, and the SEC – announced a plan, or outline, for the Treasury to buy up bad debt in the financial sectors, notably for mortgage backed securities from Fannie Mae and Freddie Mac in order to strengthen the housing market. Congressional approval will be needed for any comprehensive plan which is expected to be submitted this coming week.
The bottom line is that credit and equity markets responded significantly to Fed and Treasury actions. Credit and equity markets would likely to have come to a standstill without the actions. While long-term solutions are still to be found, both the Fed and Treasury have been appropriately creative in temporarily solving the latest credit crunch.
 Equities were on a huge roller coaster ride. For the first time, the Dow had 300+ point movements in four of five of the week's sessions. Despite the wild swings, the blue chips and techs ended the week little changed while small caps netted a strong gain.
The week got off to a bad start as the Dow dropped 504 points on Monday. The fall in equities across the board was led by financials after the announcement of bankruptcy by Lehman Brothers and with continued concern over the health of AIG. Stocks got a little boost on Tuesday due to the Fed’s FOMC statement not being as negative as feared and on rumors that federal regulators would reverse their stance and bail out AIG.
Equities plummeted again on Wednesday despite the Fed’s rescue of AIG as markets feared more financial firms and banks faced looming bankruptcy and also on the freezing up of credit markets. But stocks had their biggest rally in six years on Thursday (the Dow surged 617 points) after Senator Charles Schumer proposed that the federal government should create a new agency to buy up low quality financial assets. Rumors that Treasury Secretary Henry Paulson was working on a comprehensive plan to the credit crises boosted equities late in trading. Stocks rose further on Friday on actual news of a comprehensive financial sector fix being proposed by the Treasury, including insurance for mutual funds.
Equities were mixed this past week. The Dow was down 0.3 percent; the S&P 500, up 0.3 percent; the Nasdaq, up 0.6 percent; and the Russell 2000, up 4.6 percent.
For the year-to-date, major indexes are down as follows: the Dow, down 14.1 percent; the S&P 500, down 14.5 percent; the Nasdaq, down 14.3 percent; and the Russell 2000, down 1.6 percent.
Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.
 Despite a wild ride during the past week, most Treasury yields netted only modest changes – except for the massive drop in the 3-month T-bill rate. All yields headed down at the start of the week with traders expecting a rate cut on Tuesday by the Fed. Flight to safety was especially heavy on the first three days of the week due to seizing in the credit markets and huge declines in equities on Monday and Wednesday. Also weighing the markets were the Lehman Brothers’ bankruptcy and uncertainty over the future of bond insurer AIG. The 3-month T-bill hit essentially a zero interest rate on Wednesday with a close at 0.04 percent. Over the first three days of the week, the near end bill dropped 145 basis points.
 Flight to safety reversed in part on Thursday and Friday with the sharp rebound in equities, the Fed’s rescue of AIG, and other liquidity measures taken by the Fed and Treasury.
For this past week Treasury rates were mixed as follows: 3-month T-bill, down 56 basis points, the 2-year note, down 3 basis points; the 5-year note, up 7 basis points; the 10-year bond, up 7 basis points; and the 30-year bond, up 6 basis points.
This past week, the yield on the 3-month T-bill was at its lowest since World War II. The record low is 0.01 percent, set in January 1940.
A final note on bonds from this past week is that the growing list of government bailouts will almost certainly result in increased borrowing by the Treasury. No one yet knows the full amount of funds involved but numbers already kicked around are between half a trillion and a trillion dollars. Once credit markets stabilize and the economy improves, the borrowing is going to put upward pressure on yields.
Crude oil prices rose moderately, net for this past week. But prices fell $10 per barrel over the first two days of the week due to fears that a Wall Street meltdown would slow the economy. Adding to downward pressure were initial reports that Hurricane Ike had done less damage to production facilities than originally feared.
Oil got a boost on Wednesday as crude was seen as a safe haven from plummeting equities. Announcements of Fed and Treasury rescue plans for AIG and credit markets led oil traders to believe that the economy would fare better than feared earlier in the week. Spot oil jumped over $13 per barrel the last three days of the week.
Net for the week, spot prices for West Texas Intermediate rebounded $3.37 per barrel to settle at $104.55 – and coming in $40.74 below the record settle of $145.29 per barrel set on July 3.
The latest economic news indicates that inflation has eased temporarily but the signs of economic slowing are coming in more often than reports of improvement.
 The August dip in oil prices bumped down consumer price inflation – at least temporarily. The headline CPI declined 0.1 percent, following a 0.8 percent jump the month before. Meanwhile, the core rate slowed to a 0.2 percent rise from July's boost of 0.3 percent.
Pulling the overall CPI down was a monthly drop of 3.1 percent in the energy component, after a 4.0 percent boost the month before. Gasoline dipped 4.2 percent in August. Food inflation also slowed but remained quite elevated with a 0.6 percent increase, following a 0.9 percent surge in July. Higher production costs are still feeding into food production.
Looking ahead, the energy component is likely to reverse in September due to gasoline shortages from Hurricane Ike. The motor vehicles’ components are likely to stay soft but cannot keep declining and must level off. The economy is slowing and that will have some damping impact on lowering inflation in coming months, but first, businesses must finish adjusting to still high energy costs.
 Housing construction is still declining but there is a silver lining. Housing starts in August continued its downward spiral as tight credit and bloated supplies of unsold homes continue to depress new construction. Starts fell 6.2 percent, following a 12.4 percent drop in July. The August pace of 0.895 million units annualized was down 33.1 percent year-on-year and fell short of the market forecast for 0.950 million units. The decrease in starts was led by multifamily starts, which dropped 15.1 percent, after a 28.7 percent fall in July. Single-family starts also declined but at a much more moderate pace, decreasing 1.9 percent in the latest month, after dropping 3.2 percent in July.
The bottom line is that construction is not going to rebound until unsold inventories are brought back in line. The latest fall in new starts actually helps that process by reducing upcoming new homes entering the market. While that is not good news for homebuilders for now, it does begin the process of helping to prop up house prices. And that is a good thing for the mortgage industry as house prices need to stabilize to improve both refinancing and the willingness to make new mortgages.
The manufacturing sector is adding to the odds that third quarter GDP could end up flat or worse. Industrial production in August fell sharply with declines somewhat widespread. Overall industrial  production fell 1.1 percent in August, following a 0.1 percent rise in July. The all important manufacturing component dropped 1.1 percent, after a 0.1 percent rise in July. Utilities output fell 3.2 percent in August, while mining output decreased 0.4 percent.
For manufacturing, weakness was primarily due to an 11.9 percent drop in motor vehicles & parts. Excluding motor vehicles, manufacturing output slipped a more moderate 0.3 percent after a 0.1 percent dip in July.
The bottom line is that manufacturing is running at a slower pace. The July-August average is below that of the second quarter – meaning that thus far third quarter output has declined from second quarter levels. With housing and commercial construction declining, only the services sector is keeping economic growth positive. Any further decline in manufacturing could pull overall growth into negative territory but that does not yet seem to be the case. But we certainly are getting closer to flat.
 The latest Empire State manufacturing posted negative current results but pointed to possible near term improvement. The headline manufacturing index fell to minus 7.4 in September from plus 2.8 in August. But new orders, the most important reading of all, showed monthly improvement to 4.4 from 2.2 in August. Manufacturers in the region successfully pared inventory in the month, at an index of -2.3 in September, while they also continued to cut back on their workforces with the number of employees index at -4.6 vs. July's -4.5.
Looking ahead, the six-month outlook indicates that respondents see substantial strengthening in general business conditions, with this index rising to 43.1 from 34.6 in August. This adds to the odds that manufacturing may be near bottom.
 The string of eight consecutive negative reports from the Philly Fed manufacturing survey came to an end with a surprise modestly positive headline number. The headline index jumped to plus 3.8 in September from minus 12.7 in August. There also was good news about the near term outlook as new orders rose to plus 5.6 from minus 11.9 in August. The six-month outlook for new orders also jumped -- to 44.2 from 39.4 the prior month.
Mid-Atlantic manufacturers expect improvement in business conditions over the next six months as the future general activity index increased from 27.6 in August to 30.8 in September, its highest reading since last October. Indexes for future new orders and shipments both increased for the third month in a row. Again, another manufacturing survey offers hope that the dip in industrial production will be short lived.
 The economy appears to have dodged recession during the first half of 2008 and thus far in the third quarter. But the Conference Board's leading index is pointing to possible recession in the fourth quarter. The index of leading economic indicators fell a steep 0.5 percent in August on top of July's even steeper 0.7 decline. But these readings are aimed at predicting economic activity three to six months ahead. The index of coincident economic indicators – which measure current activity -- slipped only 0.1 percent in August, following no-change in July.
For now, the latest readings of the coincident index indicate no recession just yet. However, a big caveat is that these coincident index numbers do get revised, back to at least April for the personal income component. Technically, we could still get the National Bureau of Economic Research (the folks who officially declare recession dates in the U.S.) eventually saying recession started in April if numbers are revised down that far back and by enough. This is somewhat in contrast with the view that 3.3 percent GDP growth for the second quarter means no recession. But GDP measures growth in average activity for each quarter while the coincident index looks at monthly growth rates which can swing within a quarter. Whether or not we're in recession, growth is still very sluggish.
 The Fed surprised the markets by keeping the fed funds target rate unchanged at 2.0. The fed funds futures market before the decision had actually concluded that there was a 100 percent chance for at least a 25 basis point cut with a minority expecting a 50 basis point cut. But the Fed took the high road and is focusing on the difference between providing liquidity versus subsidizing credit.
The Fed decision was unanimous with a vote of 10-0 - somewhat of a contrast with recent meetings in which there has been more dissention. At the last meeting, Dallas Fed President Richard Fisher voted for a rate increase. Also, the August discount rate meeting minutes indicated that three regional Fed banks had asked for the discount rate to be raised. The Fed appears to want to present a united front on the issue of how to address current credit market problems -- notably the fallout of the Lehman Brothers bankruptcy and the AIG insolvency.
The tone of the Fed's statement is similar to recent ones with equal emphasis on downside and upside risks, calling them "balanced." What markets are giving too little attention is that the Fed still is focusing on market fragility, recognizing that a problem still exists. The key new language is the reference to "ongoing measures to foster market liquidity" as part of why the economy eventually strengthens. The bottom line is that the Fed is focusing on liquidity rather than lowering interest rates further.
Actions taken by the Fed and the Treasury did much to bolster market confidence and improve liquidity. But the economy is still sluggish and will likely remain so for a number of months.
The only two market moving indicators this coming week will be durables orders and GDP. But also getting attention will be reports on new and existing home sales – giving us an update on whether housing is bottoming yet.
Existing home sales rose 3.1 percent to a 5.0 million annual rate in July. But the rise did not make a dent in supply on the market, which was still severely bloated at 11.2 months and up from 11.1 months in June and 10.8 months in May. Unsold inventories continued to weigh on prices which fell 1.3 percent in the month to a median $212.4 million for a 7.1 percent year-on-year decline. There are mixed signals on whether sales will pick up further in August. The latest pending home sales index fell 3.2 percent in July while the Mortgage Bankers Association’s purchase applications index was little changed over the month of August.
Existing home sales Consensus Forecast for August 08: 4.92 million-unit rate
Range: 4.80 to 5.15 million-unit rate
Durable goods orders in July were surprisingly strong -- even after discounting a surge in aircraft orders. And businesses are looking past current weakness in the economy, continuing to invest in the economy. Durable goods orders advanced 1.4 percent in July and matching the 1.4 percent surge in June. Excluding the transportation component, new orders increased 0.7 percent, following a 2.6 percent jump in June. Strength was moderately widespread. July's gain was the largest since a 4.1 percent surge in December 2007. Apparently, exports are still providing support for the manufacturing sector along with a moderate uptrend in equipment investment in the U.S., despite a slowing in consumer spending. But the outlook is mixed, according to recent manufacturing surveys. The new orders index in the ISM manufacturing survey remained slightly negative in August while the same index in the Empire State Survey turned slightly positive in September (this report is based on responses from late August and early September). The Philly Fed’s manufacturing survey for September showed a rise in new orders (also based on responses from late August and early September).
New orders for durable goods Consensus Forecast for August 08: -1.6 percent
Range: -5.9 percent to +0.6 percent
New orders for durable goods, ex-trans., Consensus Forecast for August 08: -0.5 percent
Range: -2.5 percent to +0.4 percent
Initial jobless claims rose 10,000 in the week ending September 13 to a 455,000. The four-week average rose 5,000 to 445,000. It appears that the bump up in initial claims is related to a jump in filings from Louisiana, the result of Hurricane Gustav and the inability of residents to file during the prior two weeks. But there is still uncertainty over the general direction of claims due to likely filings related to Hurricane Ike and the government's emergency efforts to widen those eligible for unemployment benefits.
Jobless Claims Consensus Forecast for 9/20/08: 445,000
Range: 425,000 to 480,000
New home sales have been showing no sign of improvement while supply on the market is coming down. New home sales came in at a 515,000 annual unit rate in July and, importantly, sales for June and May were both revised lower by a combined 46,000 units. Year-on-year sales were down 35 percent. But homebuilders have been cutting back on construction as new homes on the market fell 23,000 in the month to 416,000, pulling down the months' supply to 10.1 from 10.7 in June and 10.8 in May. The median sales price rose 0.3 percent in the month but was down 6.3 percent on the year.
New home sales Consensus Forecast for August 08: 510 thousand-unit annual rate
Range: 490 thousand to 530 thousand-unit annual rate
GDP growth for the second quarter was revised up sharply to 3.3 percent from the initial 1.9 percent. The upward revision was primarily due to upward revisions to exports and durables consumption. The second quarter jump followed a modest 0.9 percent increase the prior quarter.
On the inflation front, the GDP price index was revised to an annualized 1.2 percent - up from the initial estimate of 1.1 percent. The sharp easing in overall price index was technical in nature, caused by a spike in nominal imports cutting into nominal GDP growth. In contrast, the inflation for final sales of domestic purchases was revised up to a strong 4.3 percent, compared to the initial estimate of 4.2 percent Headline PCE inflation was unrevised at 4.2 percent and up from 3.6 percent in the first quarter. Core PCE inflation also was unchanged--coming at 2.1 percent from 2.3 percent in the first quarter.
Real GDP Consensus Forecast for final Q2 08: +3.3 percent annual rate
Range: +2.9 to +3.5 percent annual rate
GDP price index Consensus Forecast for final Q2 08: +1.2 percent annual rate
Range: +1.2 to +1.3 percent annual rate
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