Daily Insight

U.S. stocks closed higher on Wednesday after a better-than-expected industrial production reading offered evidence that the global recovery in gaining momentum.

Earnings results from Deere & Company whipped very weak estimates and this was also portrayed as having a positive effect on the market. Deere’s revenues did fall 6% for the quarter but the company also upped its revenue forecast for all of 2010. Still, overall S&P 500 fourth-quarter profit growth actually dipped a bit to 12.4% from 12.6% as of Tuesday so I’m not sure that one company truly had much impact on the market.

The broad market fluctuated during the 30 minutes that followed the release of the FOMC minutes from their January 26-27 meeting, but returned to the pre-release level an hour later – so those comments had zero effect. The same can’t be true for the bond market, which sold off – the yield on the 10-year Treasury rose 7.75 basis points.

The industrial production number surely was the primary driver. Certainly, the mortgage applications and import price data didn’t help and I really doubt housing starts, which remain floored, offered much impetus either.

Even if housing starts were flying high, I don’t see how it excites investors as housing market demand/supply is far from equilibrium. While higher home building would boost GDP in the current quarter, it would only subtract from growth in subsequent periods as the coming shadow supply (seriously delinquent loans that are being held from the foreclosure process) will eventually hit the market and drive construction down again…unless the government just buys these mortgages and allows the delinquent borrowers to remain in the home, which I lament isn’t such an outrageous statement these days.

Market Activity for February 17, 2010
Mortgage Applications

The Mortgage Bankers Association reported their applications index fell 2.1% for the week ended February 12 after the 1.2% decline in the week prior. Both purchases and refinancing activity dragged the index lower.

Purchases fell 4.0% after dropping 7.0% in the week prior. Refinancing activity slipped 1.2% following a 1.4% pick up in the prior week. The rate on the 30-year mortgage remained unchanged, averaging 4.94% for the week.


Import Prices

The Labor Department reported that import prices jumped 1.4% in January (and increase of 1.0% was expected) largely due to energy prices, but ex-petro import prices rose 0.6% for the month so it was more than just fuels driving the reading higher.

The petroleum segment jumped 4.8% in January and has nearly doubled over the past year, up 95.5%. Food and beverage was up 1.3% and these import prices have begun to get juicing over the past three months, up 11.3% at an annual rate. Industrial supply prices jumped 3.8% in January and have rocketed 31% past three months at an annual rate.

For import prices overall, the index is up 11.5% from depressed levels of a year ago. The index is still down 15% from the peak hit in July 2008 (driven by that summer’s commodity price spike -- oil at $145/barrel) and is back to levels just before that period.

Housing Starts

Builders broke ground on 591,000 units at a seasonally-adjusted annual rate in January following an upwardly revised 575,000 in December. The January results were pretty much in line with expectations.

We don’t exactly need more housing units coming onto the market; it would be nice to see job growth come back, debt levels paid down and income growth take place first. This would set up for better conditions within the housing market. That said, roughly 600K units at an annual rate is close to zero in relative terms as the readings remain near record lows – the data goes back to 1959.

Recall the foreclosure figures we touched on again yesterday – 300K foreclosure filings a month, 2.8 million in 2009, another 3 million in 2010, a current distressed loan balance of $450 billion. We’re talking about three years before this inventory (both actual and shadow) clears, according to S&P. So any home building only extends the time to which the housing market can normalize.

Building permits, a gauge of construction over the next few months, fell 4.9% in January after a 10.9% jump in December.

Industrial Production

The Federal Reserve reported that industrial production (IP) rose 0.9% in January (an increase of 0.7% was expected), marking the seventh month of increase. The manufacturing segment, which accounts for 80% of the IP index, drove the figure this time – last month IP only rose thanks to a historically outsized 6.3% jump from the utility segment, a function of colder-than-normal weather.

The manufacturing segment looked strong in January as production rose 1.0% after a -0.1% slip in December. Motor vehicle and electronics production drove the segment.

Utility production rose 0.7% last month. The mining component rose 0.7% after a 0.2% production decline in December.

Industrial production is up 0.9% over the past year thanks to this seven-month streak. Prior to this rebound, IP fell in 17 out of 18 months.

Capacity utilization rose to 72.6% from 71.9% in December, marking the seventh month of improvement off of the record low of 68.3% in June -- the 40-year average is 81%. We’ll watch for the reading to hit 78%, which has taken between 12-24 months to rebound to depending on the recession -- this is the level that accompanies significant job growth. It took capacity utilization 12 months to hit 78% from the cycle low of 70% following the 1982 recession; it never dipped below 78% during the 1991 recession; and took nearly 24 months to accomplish from the cycle low of 73.5% following the 2001 downturn.

FOMC Minutes

The minutes from the January 26-27 FOMC meeting revealed that policy makers debated how and when to shrink the central bank’s $2.26 trillion balance sheet , with some pushing to start selling assets in the “near future.” (Just for clarity, when we talk about the Fed’s balance sheet it refers to the securities they hold as they purchased various assets in order to pump money into the system and create a lower interest-rate environment.)

I’ll believe that they’ll sell assets, like longer-dated Treasury bonds and mortgage-backed securities (MBS) when I see it – the discussion probably took place as lip service to the market as an attempt to keep inflation expectations moored. They can’t even find the muster to raise the fed funds rate to 0.75%-1.00% and we’re supposed to believe a debate took place on asset sales, please. Gradual asset sales would risk a significant jump in mortgage rates and crush the housing market. (These comments, even if actual asset sales are unlikely anytime soon, will likely push forward the markets tightening expectations, as evidenced by the pop in Treasury yields after the minutes were released.)

The FOMC declared the economy was in “recovery” for the first time and affirmed it would end liquidity backstops and MBS purchases.

On the FOMC’s signal as to how long the fed funds rate would remain floored, we knew there was a lone dissenter via the statement following the conclusion of the late January meeting, but the minutes repeated that KC Fed Bank President Hoenig opposed keeping the phrase “an exceptionally low level of federal funds…for an extended period” for something that suggests they may raise rates soon. The market believes that the fed funds target will not rise a smidge for another six months so long as they keep this phrase intact. Hoenig wanted the Fed to be more flexible, give themselves a little more leeway with adjusting the rate gently higher.

On their forecasts, policy makers also raised the low end of their 2010 economic growth range to 2.8%-3.5% from 2.5%-3.5%, but raised the low-end of their unemployment range to 9.5%-9.7% from 9.3%-9.7%. They believe that core inflation (which excludes food and energy prices) will range 1.1%-1.7%.

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Have a great day!

Brent Vondera, Senior Analyst