A better-than-expected durable goods report – which we’ll discuss below – helped buoy stocks in the morning session and investors then waited for the Fed rate decision. When that decision to cut fed funds by one-half a percentage point was announced volatility spiked. With 30 minutes left in the session, the S&P 500 was higher by 3.2%, but that all evaporate, and then some, in the final minutes. Was this due to mutual fund redemptions? I don’t know, but it sure looks like it.
Market Activity for October 29, 2008
The Rate Cut
The FOMC went ahead with what the market called for and cut their target rate on fed funds by 50 basis points to 1.00%. Of course, like so many government actions of late, the market expects it, the government delivers and… BAM! it sells off.
However, the many facilities and programs the Fed has rolled out are helping the credit markets to thaw as three-month LIBOR continues to move lower, the TED Spread narrows (although not yesterday due to flight to T-bills) and the commercial paper market is showing early signs of life. So, it’s not accurate to say there hasn’t been some degree of efficacy regarding what the Fed has done, but stock-market traders sure enjoy slapping Bernanke around.
The vote to cut was unanimous (the FOMC is made up of 12 members – seven Fed governors (including the Chairman) and five rotating spots involving the 12 regional Federal Reserve Bank presidents) to move the target down to 1.00%; “a return to the scene of the crime,” as our Senior Fixed Income Analyst Ryan Craft puts it.
Now, the effective fed funds rate is actually trading below that 1.00% target rate (as discussed yesterday) due to the massive amount of liquidity the Fed has pumped in. That effective rate should trade closer to the interest rate at which the Fed is now paying on deposits at the central bank (fed funds minus 35 basis points, or 0.65%) – which is what’s referred to as quantitative easing, I believe, and why the target fed funds rate is not nearly as important as the growth in the Fed’s balance sheet right now, which makes the other programs they’re engaged in possbile.
In the statement that accompanies the rate decision, the FOMC mentioned coordinated actions with other central banks, which should presage what the Japanese central bank does tomorrow and Europe does next week, which will be a cut of 50 basis points.
One should not expect this latest reduction back to 1.00% fed funds to stimulate from here. What it should do is help to lower three-month LIBOR, which many adjustable rate mortgages are pegged to. It was also a PR move, as the Fed does not want to disappoint the market and touch off anything that may cause stocks to plunge from here. As mentioned yesterday, I don’t agree with this and wish Fedhead Bernanke would have been more forceful with the market a few months back. If that had occurred they may not be at the whim of the stock market right now. Who knows?
Yesterday’s Economic Data
The Commerce Department reported durable goods orders for September were much better-than-expected, although it did follow a downward revision to the August figure.
Orders for durable goods rose 0.8% last month, which was considerably better than the expected 1.1% decline; this followed a large 5.5% decline in August. Orders were boosted by defense and commercial aircraft orders. Electrical equipment orders also rose nicely, up 1.5% last month, after two months of weakness for this segment. However, outside of these components orders were weak, as witnessed by the ex-transportation reading, which fell 1.1%.
Defense orders jumped 19.6% in September and commercial aircraft was up a huge 29.7%. As the Boeing strike appears to be coming to an end aircraft shipments may offer some economic boost than would otherwise be the case – unfilled orders aircraft orders are up 20% over the past 12 months.
The component we watch most closely within the durable report is orders for non-defense capital good ex-aircraft – this is a proxy for business capital spending. Business spending had been on the rise, up at a 10% annual rate in the five months ended July, but things changed quickly as the credit market freeze-up began to take hold. Firms have the resources to engage in these orders but hold off in caution due to the effects and uncertainty that the credit disturbance will have on global growth. As of this latest report, capital spending declined at an 8% annual rate since July – a serious reversal.
That said, shipments of business equipment rose 2.0% in September – which results from the healthy orders a couple of months back – will help the third-quarter GDP report as this component funnels directly into that report, but it won’t nearly be enough to offset other weakness.
We will need to get past this credit market disturbance, which seems to be incrementally thawing, before durable goods orders begin to trend higher again. The problem even as we get beyond this event is the tax policy that had spurred a rebound in capital spending three months back (higher current-year write-down allowances and bonus depreciation) will end in January. It would be a fabulous idea for the administration to demand that this policy is extended through 2009 – the McCain campaign has this in there agenda, but it appears unlikely they’ll get the chance to implement it.
It’s Thursday, so this morning we get initial jobless claims, which will remain elevated. We’ll also get the initial estimate to third-quarter GDP, which will mark the beginning of a traditional recession, which began when Lehman went down in September and the credit markets froze up. Prior to that point, many had stated the U.S. was in recession – and certainly the job market was weak and the consumer side was showing trouble – but recession was not true as the business side was upbeat, as business spending and sales were moving higher. That has changed.
We should expect a reading of -0.5%, maybe even something close to -1.0%. The fourth quarter reading will be the big one, as we’ll probably see a reading of -3.0%, possibly as high as -4.0%. Those are negative figures we haven’t seen since the 1990-1991 recession – a traditional recession.
Moving to Policy
We hear a lot about what’s caused the current economic situation, unfortunately, the much talked about “causes” are not the causes at all and miss exactly that which has delivered this state of affairs.
If we are to blame historically low tax rates, free trade, flexible labor markets and entertain the de-regulation myth, as some have, we’re in for deep trouble. The origins of this crisis are monetary policy mistakes (keeping rates too low for too long), congressional demands to offer credit to less than creditworthy consumers and an insane decision to switch to Basel II banking standards (and mark-to-market accounting) in the midst of the housing bubble – which has caused capital ratios to look much worse than would be the case under the former, more stable, standards.
To ignore the true origins of this situation, and instead kill the fundamentals of a relatively free economy the next few years are not likely to offer the optimal economic outcome. Eventually, we will choose the correct policy, but to raise taxes, eliminate trade pacts and regulate everything under the sun (specifically overlapping regulation) will spell economic death, at least a coma, especially in the current environment – I believe much of the damage in the stock market has been a pricing in of this scenario.
If we are to lower after-tax returns (by raising tax rates) on those that provide the capital for innovation, business start-ups and overall financing for the economy everyone else is not made better-off, but just the opposite.
Low tax rates on capital drives the formation of capital; capital funds (and thus drives) innovation; innovation drives productivity; higher levels of productivity drives competitiveness; increased competitiveness drives jobs. Period.
Remember these economic axioms the next time you run into a politician claiming to raise taxes on the “rich,” for it is the rest of society that will pay.
Have a great day!
Brent Vondera, Senior Analyst
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