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No sooner had we sent
our May 2008 Economic and Market Perspective to the printer
than the hopeful stock market rally following the announced
sale of Bear Stearns to J.P. Morgan petered out. We had
suggested that markets would continue to struggle in the
face of lingering concerns over the credit crisis and uncertainty
regarding the likely course of the economy. And that's
what we're seeing. Expect more of the same.
Since May, little has
changed in the grand scheme of things. But, as always,
the particulars that prompt market moves over short periods
of time are interesting. More importantly, they generally
offer supporting detail to the broad brush strokes offered
up by strategists and economists, and sometimes they introduce
new twists, or even hints that trends are about to change.
What
remains the same?
First, the housing market
remains in recession, and a bottom is not within sight.
House prices continue to decline, subprime teaser rates
continue to reset, delinquencies and foreclosures continue
to increase, and inventories of unsold homes continue to
rise. Of course, there have been a few snippets of data
to suggest the possibility that we're approaching a bottom;
pending home sales for April advanced 6.3% versus for March,
and mortgage refinancing applications advanced over 10%
for the same period. But these were likely responses to
discounts available on the huge inventories of foreclosed
properties being dumped on the market. The weight of fundamentals
remains toward the downside.
Second, the economic
data remains mixed, making a confident forecast regarding
recession nearly impossible. Economic data that has been
reported since the completion of our May report continues
the mixed pattern. For instance, retail sales for May came
in at 1.0% versus April's, twice the rate expected by market
analysts. Subsequent commentary attributed this result
to the unexpectedly strong impact of the government's stimulus
package initiated in the early part of the month, suggesting
such strength would prove unsustainable once all the checks
have been sent out by the early part of July. On the other
hand, the May unemployment rate jumped to 5.5% from 5.0%
in April after having declined 0.1% from March to April.
However, analysis of the details revealed that most of
the increase was attributable to a flood of teenagers and
college graduates entering the workforce in search of employment.
The implication is that new entrants unable to find jobs
is not as bad for the economy as the situation in which
current job holders are losing their jobs. The point remains
that the job market is weak, but not weak enough to signify
a recession.
Third, the credit crisis
has at least temporarily achieved a stasis in response
to much lower interest rates, newly implemented liquidity
facilities provided by the Federal Reserve, and action
by the administration and Congress to provide tax cuts
and some limited support for certain classes of mortgage
holders in jeopardy of losing their homes. Similarly, financial
institutions have taken nearly $400 billion in write-offs
and have been partly successful in replacing capital through
new security issuance, whether to private equity funds,
sovereign wealth funds, or through public offerings of
stocks and bonds.
What
is different?
In reality, not much.
But there has been a decided shift in emphasis of concern
on the part of the Federal Reserve over the past few weeks.
In a series of speeches by various Federal Reserve governors
and administration spokespersons, worries about recession
have ostensibly been demoted in favor of fears of inflation.
The backdrop to this change on the margin has been the
almost unrelenting advance of commodity prices. Since the
beginning of April, crude oil has advanced nearly 35%!
And the price of a bushel of corn has jumped nearly 60%
since the beginning of the year, although half of that
rise has come in the past few weeks in response to Midwest
floods. Mercifully, industrial commodities have not advanced
recently, but most remain close to historical highs.
The rise in these real
world prices is beginning to show up in the reported economic
data. The Consumer Price Index (CPI) for May was just reported
to have advanced 0.6% versus for April, worse than the
consensus expectation of 0.5%, and 4.3% on a year-over-year
basis. That was the highest year-over-year reading since
the cyclical high of September 2005, and before that, since
July of 1991! The "good news" is that the core
CPI (the one that excludes energy and food) was only up
2.3% year-to-year. Interestingly, the solace of a relatively
low core CPI reading seems to be evaporating as the reality
sinks in that dramatic increases in energy and food costs
are really beginning to hurt consumers both psychologically
and in their pocketbooks. The same is happening to corporations
that are finding their margins being squeezed because
they cannot fully pass on their escalating costs.
Similarly, import prices
have continued to advance at an accelerating pace. In May,
import prices advanced 17.8% year-over-year, up from a
16.3% pace recorded in April. Of course, a large part of
these increases derives from oil imports. But their effect
is to dilute the positive impact of strong domestic exports
on our net trade deficit and, thus, on reported GDP.
As a result, the Federal
Reserve and administration spokespersons including Treasury
Secretary Paulson and President Bush himself have recently
begun, uncharacteristically, to make reference to a preference
for a strong U.S. dollar. A stronger dollar would help
combat import price inflation and might actually reverse
the escalation of commodity prices, or so goes the thinking
among some economists. Others observe that a stronger dollar
could undermine the one growth driver of the U.S. economy
that remains, namely, strong export growth. And it is a
matter of conjecture that a stronger dollar would significantly
undermine commodity inflation despite the fact that commodities
are denominated in U.S. dollars.
Thus, over the past
month, official statements have publically raised for the
first time in years the specter of potentially runaway
inflation as well as the specific desire to see a stronger
U.S. currency. The implication is that the Federal Reserve's
interest rate reduction regime is finished and that the
next move is likely to be up, and up much sooner than most
would have anticipated only weeks ago. In fact, futures
markets have recently been signaling an expectation of
a 50 to 75 basis point hike in the Federal Funds rate by
the end of this calendar year. The Treasury yield curve
has responded by a very rapid and dramatic shift upward,
with the 2-year Treasury yield and the 10-year Treasury
yield advancing 65 and 35 basis points, respectively, in
the week between June 6th and June 13th! Looking back just
a bit further, it is clear that the bond market was already
worrying about inflation and anticipating the potential
for the Fed to begin raising rates. Since Monday, March
17th, following the weekend demise of Bear Stearns, the
2- and 10-year Treasury yields are up 168 and 95 basis
points, respectively.
The
box
The problem with all
of this is that an increase in interest rates at this time
is likely to plunge the U.S. economy into the recession
that the Federal Reserve has ostensibly been attempting
to avoid. In effect, the Fed is "boxed in" by
its dual mandate to simultaneously maintain economic growth
and contain inflation. During the past 20 years, while
inflation has been generally well-behaved except on a cyclical
basis, the Fed could direct its policy actions toward managing
growth.
Today, with signs of
inflation bubbling up everywhere, the interest rate lever
becomes a clumsy tool. Raising rates now to attempt to
undermine rising inflation expectations threatens immediately
two goals of the Fed's recent rate reduction regime, namely,
creating a steep yield curve to enable the banking system
to re-capitalize and re-liquefy (borrow at low rates, lend
at higher rates), while providing lower mortgage interest
rates in hopes of stoking a housing recovery. Note that
the changes in Treasury yields highlighted above imply
a flatter yield curve, thus diminishing the spread between
what banks must pay for funds and the rate they can charge
for lending those funds. That spread represents bank profits,
the feedstock for capital replenishment, which in turn
is the fuel for generating growth in the economy.
For these reasons, we
are skeptical that the Federal Reserve will in fact raise
interest rates much, if at all, over the next six months,
unless forced to do so. Our guess is that all the recent
talk is just that, talk, "jawboning," in an attempt
to contain inflation fears. That is a dangerous game because,
first, such efforts always fail if not backed up by action,
and second, bluffing is the last resort of the player with
a weak hand, and the others at the table know that.
For instance, the European
Union, which has stated its intention to raise rates, will
almost assuredly do so. The EU monetary authority only
has one mandate, contain inflation to a rate of no more
than 2.0%, period. Having maintained its policy rates at
4.0%, 200 basis points higher than those of the Fed, the
EU has a much stronger position from which to act. A rate
increase by the EU may in fact force the Federal Reserve
to raise rates because, otherwise, the recent strengthening
in the dollar against the Euro will be reversed, and the
dollar could sink to new lows, exacerbating domestic inflation
and further undermining confidence in the U.S. dollar's
status as the world's reserve currency.
We believe the Federal
Reserve is fully cognizant of the dilemmas it faces. That's
why it is trying to balance its responses to the dual threats
posed by inflation on the one hand and recession on the
other. The short term risk is that, in attempting to fight
on several fronts, it confuses the markets and creates
uncertainty and volatility. That surely seems to be what
has happened in the past couple of weeks as demonstrated
by the dramatic rise in rates and flattening in the yield
curve. However, the Fed's job, as noted above, is to fight
both inflation and recession. If the economic data holds
up over the next couple of months, the Fed could probably
afford to take a 25 basis point increase in the Fed Funds
rate sometime in late summer, early fall. Such an action
would signal avoidance of recession, initiative to rein
in inflation and awareness of the need to reestablish credibility
ofthe U.S. dollar. We believe the Fed's recent public comments
have been an attempt to maneuver itself into a position
to be ready to make that policy adjustment as soon as it
has some confidence that conditions in the economy and
financial markets have stabilized.
The
views expressed in this article are subject to change at
any time based on market and other conditions, and should
not be construed as a recommendation. This article contains
forward-looking statements, which speak only as of the date
they were made and involve risks and uncertainties that could
cause actual results to differ materially from those expressed
herein. Readers are cautioned not to rely on our forward-looking
statements.
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