Daily Insight

U.S. stocks ended the session higher, but traders appeared confused during the hour of trading subsequent the Fed’s rate decision – and just as importantly the statement, which was extremely non-committal – as the major indices gyrated more than 1%, as the graph below illustrates. In the end the indices held onto to most of the pre-announcement gains.

During the morning session, stocks shook off another very weak new home sales number – this time for May – as a pretty good durable goods report helped investor optimism. That report showed orders were flat for May, but electronics, computer products and telecommunication equipment showed nice gains and shipments of capital goods, which flows directly to the GDP figure, gave good indication second-quarter growth will be stronger than expected. More on this later.

Market Activity for June 25, 2008
Crude oil futures fell roughly 4% as the weekly energy report showed supplies rose 803,000 barrels – the forecast was for a decline of 1.1 million barrels. Fuel demand averaged 20.2 million barrels per day during the past four weeks, down 2.3% from a year earlier. Crude recovered half of this decline after the Fed’s comments showed they still don’t get it, which we’ll also get to below.

Eight of the 10 major industry groups gained ground for the day; energy and industrials were the losers. Energy was down on the decline in crude futures and industrials were pushed lower by a nearly 7% decline in Boeing shares, which sent many of the aircraft suppliers down in sympathy. But this concern was overplayed and the suppliers, especially those with strong defense contracts, are looking quite attractive here. The decline in Boeing shares subtracted 41 Dow points from the index, which is why it lagged the performance of the S&P 500.

Getting to the economic data, new home sales fell 2.5% in May, brining sales to 512,000 at an annual rate. There’s not much more to say about this situation, you’ve all heard it before. Supplies are terribly elevated and buyers simply will not come back to the market in earnest until they get a sense that prices have bottomed.

Expect housing – residential fixed investment in technical terms – to continue to weigh on the GDP figures, which has been the case for nine quarters now. During eight of these quarters, housing has subtracted at least 1.25 percentage point from real growth, yet economic growth has still measured 2.35% in real terms during this nine quarter period. Add in the 1.25 percentage point and you’ve got above trend growth even with sky-high energy prices – that proves underlying strength remains.

I’m guessing housing will bottom sometime in mid-2009, but this assumes Congress doesn’t do anything stupid to prolong the correction, which is a big assumption.

In a separate report, the Commerce Department reported that May durable goods orders came in flat. What kept the figure flat from the April reading was a big drop in machinery orders, down 5.3%. Strong orders in April and March – up 5.1% and 8.5%, respectively – caused the machinery orders respite. Vehicles and parts also weighed on the figure, which as been a reality for several months now. Those orders were down 3.5% and many auto plants remain idle.

The strength came from electronic, computer products and telecommunication equipment, which all posted really nice gains. Electronics orders were up 2.0%; computer products orders were up 10% and telecom orders rose 2.4% for the month.

Non-defense capital goods ex-aircraft – a proxy from business spending -- slipped 0.8% in May due to that drop in machinery orders. The decline followed a 3.1% rise in April. Importantly, shipments of business equipment rose 0.6% last month, which was on top of a 0.9% increase for April. This number is a component of GDP and thus will help the Q2 reading.

Finally, getting to the big news of the day, the FOMC (Federal Open Market Committee) kept their benchmark interest rate unchanged and the statement that accompanied the decision was non-committal.

The Fed mentioned overall economic activity continues to expand, reflecting some firming in household spending. However, they also mentioned that labor markets remain soft and that the housing correction and high energy prices will likely weigh on economic growth.

This latter statement was damaging. We already know this and all stating it does is send a signal that they may not raise rates in August. This is bad for the short-term price of oil – we needed a strong statement proving Bernanke and Co. understand that a mild boost in fed funds will bring crude futures lower.

The Fed certainly stuck to their Keynesian roots by mentioning they expect inflation to moderate later this year simply because growth is weak. This has been their line for six months now, only to be way wrong as their easy money campaign has hit the dollar and boosted commodity prices.

I’ve got to say my initial reaction to the statement was that it did signal the rate-hiking will begin in August – basically because of the “economic activity continues to expand, reflecting some firming in household spending” comment. Alas, the market didn’t see things the same way.

I lament, the language was not nearly strong enough – they needed to be much more hawkish towards commodity-price inflation. This was evident shortly after the comments were released as the dollar declined – after being flat-to-higher prior to the statement; oil reversed course – erasing half of it earlier losses – and the probability of a rate hike in August (their next meeting) declined.
Overall, the FOMC release was a big let down and we’ll likely have to deal with a dollar that struggles to gain ground and thus oil prices that remain above $100 per barrel, possibly above this $130 mark as the Fed is directing short-term traders to stick to the commodity trade.

There will be a new Fed Chief by the end of 2009. Bernanke is a fumbler and fails to get what will actually help economic growth in the relative short term.

This is a confused Fed. They certainly have a tough job in front of them, but they must understand that 2.00% fed funds will not magically solve the housing and credit issues and concentrating on the dollar and commodity prices is their best lever at this point. Mild tightening, beginning with what should have been strong and decisive comments yesterday, is the best way they can boost growth over the near term.

Have a great day!

Brent Vondera, Senior Analyst