Daily Insight

Wow! Market activity was all over the road yesterday as stocks began the day roughly 1% higher on a meaningful decline in oil prices – thanks to some comments from the G7 on Sunday night – and the dollar was up big. But that all changed two hours into the session after a Lehman analyst stated the GSEs Fannie Mae and Freddie Mac may have to raise $75 billion in capital. By noon, the Dow had dropped 278 points from the intraday high and barely recovered from there by session’s close.

These comments on the GSEs (government sponsored entity) received all the press for pounding the market, but an address by San Francisco Fed Bank President Janet Yellen did major damage as well, which we’ll get to below. For now, suffice it to say her statements reversed the dollar’s rally and helped crude futures reverse roughly half of its earlier losses.

In the end, the major indices closed less than 1% lower, with the Dow down just 0.5% and the NASDAQ losing 0.1%, but it was worse than that considering stocks were in rally mode at the open.

Market Activity for July 7, 2008

Not helping the Dow were shares of General Motors, which have declined to the lowest level since 1954. Between GM’s management and the UAW, it’s been very difficult for the firm to compete on a global scale. But Bernanke & Co. have delivered what is very close to a coup de grace with their reckless monetary policy – it is no coincidence that crude oil is up 75% since September, the point at which the FOMC began their rate-cutting agenda. Since becoming absurdly aggressive, kicked off by the January 22 inter-meeting cut, oil is up 60%. GM is not face with a demand problem; they are troubled with having too much supply of trucks and SUVs, while not enough of what the public now desires – more fuel efficient vehicles – after the stunning climb in energy prices in the past several months.

Getting back to the market and investors’ concerns, here’s the kicker regarding the Fannie (FNM) , Freddie (FRE) news: it was all conjecture.

FNM, FRE took a dive after a Lehman Brothers analyst stated accounting rule changes would force the two to raise capital, and thus make it more difficult to buoy the housing market – if you can call it that. But that very same analyst, and naturally not reported on until well-after the close, agreed that such an outcome would not occur. In fact, he stated that he could not “imagine such an outcome occurring.”

So all of this wild ride was over a hypothetical statement. The Dow falls 278 points intra-day, FNM and FRE lose 20% and the market has allowed yet another dark cloud to roll overhead all based on some comments that will likely not come to fruition.

With all of the concerns related to mortgage loans, and the financial sector, the Ted Spread appears to be holding in there pretty well – it is certainly elevated, but no where near the widening that occurred during heightened stints of credit-market concern. This spread is an indication of credit risk as it illustrates the difference between three-month futures contracts for U.S. Treasuries and Eurodollars having identical expiration.

The reasoning: Since U.S. T-bills are considered the risk-free rate, while the rate associated with the Eurodollar is thought to reflect the credit ratings of corporate borrowers, the wider spread is an indication default risk is increasing. Naturally, a narrower spread means default risk has diminished.

But the 30-year mortgage spread does remain wider than usual against the 10-year Treasury. This spread normally runs between 150-180 basis points – that is, the 30-year mortgage rate is usually about 1.5-1.8 percentage points higher than the 10-year Treasury. Currently, the spread is running about 235 basis points as the market demands more via heightened risk. The chart below may look a bit confusing, but focus on the yellow line, which is the spread.

Considering these two spreads, we see that concerns remain heightened, but are lower than the worries of March.

Outside of these housing/credit-market concerns there was also something else that hurt stocks, and that was San Fran Bank President Janet Yellen’s speech. The graphs below show what happened to the dollar and oil when her comments hit the wires.

The address was focused on the current state of the economy but it was her comments on commodity prices, as she explicitly stated there is little monetary policy can do to prevent the rise in oil prices, that did the damage. She also said that the Fed doesn’t have a definitive answer for why food and energy prices have gone through the roof, but suspects it’s resultant of supply/demand. Oh, I see, supply/demand has changed so dramatically in six months that it justifies a 60% rise in crude prices.

It’s true that the rise in food prices is partially due to supply issue as heavy rains have kept farmers from getting into the field to plant. It is true that oil prices had risen from $40 per barrel in late 2004 to $70 per barrel by mid-2007 due to increased demand while we refuse to produce the vast majority of our energy reserves. However, the rise from $70 to $140 in the past 10 months is due to reckless Fed policy. It is amazing that Fed officials continue to tow the line Yellen repeated yesterday. It is not simply chance that energy has risen this much in such a short period of time as the Fed has also jacked rates lower and punished the dollar in the meantime.

I believe when the Fed changes their stance on this issue and signals just mild tightening will take place in order to boost the dollar, lower energy prices and fight inflation, the market will rally hard. It may take a day or two to digest it all, but a major uncertainty will have been removed – the question: is the Fed really focused on curtailing price pressures or will they remain lost in the wilderness of their Keynesian textbooks? – and stocks will find their groove. The search party continues, but I do believe the Fed will be found before we move to a 1970s like situation.

Crude prices are lower this morning, falling below $140 per barrel, and the dollar is lower after some very constructive statements out of the G7 conference last night. (It’s actually the G8, but I don’t recognize Russia’s membership, which is a joke and nothing but a thorn in everyone’s side).

Alas, Bernanke speaks this morning, so don’t be surprised if oil and the dollar reverse their desired direction this morning.

Have a great day!

Brent Vondera, Senior Analyst