Daily Insight

U.S. stocks fell as the Federal Reserve’s statement that accompanies the close of their FOMC meetings failed to augment confidence that the economy is capable of strengthening on its own. Still, the market loves easy money and the Fed definitely reinforced that they will keep the policy as loose as it gets, so even with the lack of self-supporting confidence in the economy its was kind of surprising to see stocks decline nearly 2% in the final hour of trading.

Then again, until yesterday, we haven’t had a daily decline of more than 0.34% in the S&P 500 since September 1 so I guess it shouldn’t be all that surprising to see a buy on the rumor (hitting a multi-month high on Tuesday) and sell on the news event in the stock market.

The broad market hovered around the flat line for most of the session, rallying immediately after the Fed’s statement was released. However, a closer view of the statement (when people actually took time to read it) showed the Fed remains quite concerned about the prospects for economic growth and what the market’s reaction will be when the QE (bond buying) campaign comes to an end.

Nine of the 10 major industry groups closed lower, telecoms being the only one that gained ground. Financial, basic material and energy were the worst performers.

Market Activity for September 23, 2009
Mortgage Applications

The Mortgage Bankers Association’s applications index jumped 12.8% in the week ended September 18 after falling 8.6% in the week prior. Purchases rose a strong 5.6% and refinancing activity ran up 17.4%. Applications to purchase a home are down 14.9% from this time last year, yet refis have soared by 41%. Refinancing activity accounted for 63.8% of all applications in the week.

The 30-year fixed mortgage rate fell below 5.00% late May, ending the latest week at 4.97% -- this sub-5.00% level is the sweet spot for refis and needless to say doesn’t hurt purchases either. The first-time home-buyers tax credit and foreclosure-driven price declines have also fomented the rebound in sales.

The questions from here is what happens to mortgage rates when the Fed’s bond purchases come to an end (currently they have bought $810 billion of the $1.45 trillion in mortgage-backed and agency debt scheduled) and whether or not the tax credit will be extended past November.

Crude

Crude oil for October delivery moved back above the $70 per barrel mark Tuesday, but dipped early-morning yesterday after a preliminary energy report showed stockpiles increased. When the official Energy Department report was released at 9:30 CT, oil continued its move lower as that report showed crude inventories rose 2.86 billion barrels to 335.6 million – inventories were forecast to fall 1.4 million. Crude settled in to close at $68.97 for the session.

This keeps the current level of crude inventories about 5% above the five-year average, which is telling considering the daily average of crude imports remains 10% below year-ago levels – this shows fuel demand remains weak.

Refiners idled some plants for seasonal maintenance reasons, which also played a role in the demand dynamics.

So between the low demand/elevated inventory situation, it makes it kind of tough to justify $70 per barrel oil, maybe a number closer to $50 makes more sense from a supply/demand basis. But the reality is the dollar continues to get blasted and individual investors and governments are looking for alternatives to currencies as a way to guard against their declines. When this is factored in…well, $70/barrel doesn’t seem all that out of line – oil has become quite the dollar hedge over the past couple of years, supplanting gold to a degree.

FOMC Meeting

The Federal Open Market Committee stated:

On the economy:

“[E]conomic activity has picked up following its severe downturn. Conditions in financial markets have improved and activity in the housing sector has increased. Household spending seems to be stabilizing, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.”
(This statement changed vs. their statement following the August meeting from: “economic activity is leveling out” and “household spending has continued to show signs of stabilizing”)

“Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.”
(The previous statement was the same expect for they did not mention “at a slower pace.”)

“[A]lthough economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.”
(The previous statement was, “the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.”)

I also have to add my own comment to this segment of the statement. It really is a nice thought, but I don’t see how policy takes this direction, and is effective in bringing growth back, without a heightened inflation consequence – that’s a pretty little world to live in. Further, and this is very important, notice how they dropped the sustainable growth phrase. They know that the massive easing campaign they have engaged in has brought the economy out of trough levels for now, but it cannot contribute to sustained economic growth because when this aggressive policy is reversed it will cause the economy to retrench.

On interest rate policy:

“The Committee will maintain the target range for the federal funds rate in a range of 0-0.25%and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

On quantitative easing (QE):

“To provide support to the mortgage lending and the housing markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt.” The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010.”
(The previous statement was, “the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion in agency debt by the end of the year”)

They left some leeway in the previous statement, implying they may not buy all $1.25 trillion in mortgage-backed securities. Now they state they will gobble up the entire $1.25 trillion – not unexpected, but it is a change in the language. The extension of this program from the end of the year to the end of first-quarter 2010 was a very good decision. It’s already going to be a tough thing for the market to deal with when this buying come to an end as bond prices have adjusted to the current policy. They will need all the smoothing out they can muster, and the extension allows them this luxury.

Some additional comments on these statements:

I’ve got so much to say, but I’ll keep it concise. Simply put, the economy remains in a precarious and fragile position. The very fact that the Fed will continue to support the economy with an unprecedented level of monetary policy easing makes this abundantly clear.

I also found it strange, not surprising but strange, that the members of the FOMC appear almost ebullient on their inflation outlook as they believe the output gap (low capacity labor and utilization rates) will keep a lid on inflation pressures. Interesting how they ignored the increase in commodity prices – quite convenient.

What’s more, since they are intensely focused on the output gap, they are signaling policy will remain very easing for quite a while still – capacity utilization rates are just above their record low, currently at 69.6% (these records go back to 1967). It will likely take a long time to get it back to the long-term average of 81%. For context, it took nearly two full years for capacity utilization to go from 71% in 1982 to 81% by 1984, and that was with one of the most powerful periods of growth in the history of the United States – the economy grew at a 7.75% real rate in 1983 and 5.6% in 1984.

And on the duration of this easing, the Fed is focused on repairing household balance sheets by using an extreme easy money stance to encourage an equity market surge from the March lows. They accomplish this by reducing alternative investments, such as fixed income investments as yields remain very low. But they forget about the alternative they cannot control – commodities. The risks of another fed-induce bubble remains very much in play.



Have a great day!


Brent Vondera, Senior Analyst