Economic Trends and Risks

Fed Ease Returns Policy Rate to 50 Year Low

The Federal Reserve's 1/2% cut in the policy rate Wednesday matched market expectations and comes just three weeks after the coordinated policy ease with the ECB, Bank of England and other Central Banks which pushed global rates lower.

The irony is that the current 1% federal funds policy rate now stands at the same 50 year low partly blamed for the run away credit markets earlier in the decade.  However, the level of the policy rate isn't really the issue, its the lack of liquidity in the banking system due to the fear of counterparty risk and its upward effects on related interest rates such as Libor, asset backed commercial paper and a number of other key rates used by the markets to borrow. 

The Fed's statement noted weakened economic conditions.  Consumer expenditures has slowed markedly as business equipment spending and industrial production have weakened.  The slowing economic activity in many foreign economies is damping the prospects for U.S. exports.  Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

Recent policy actions, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, the Fed noted that downside risks remain.

False Signals

Some improvements in the September homes sales figures suggest that demand is strengthening and leaving lower inventory levels -- the first step for a swing in the recessionary housing sector.  I argue  strongly to beware false signals of improvement.  Housing isn't set up for an upturn yet.  

Existing home sales rose 5.5% to leave a 1.4% gain from a year ago with the strongest level in over a year.  Surely that could at least argue for growing sales stability.  But remember, existing sales include the foreclosures which are setting off stronger price declines and increased hesitancy to buy.  The National Assoc. of Realtors which puts the figures together estimate that 35%-40% were distressed sales as the majority came from the West where prices have plunged -19% over the last year.

The deepening recession continues to delay any upturn in home demand.  A sharply rising unemployment rate, rapidly falling equity prices, extremely low consumer confidence and tighter mortgage credit argue against near term improvement.  Market expectation for a continued fall in housing prices leave little reason to step in if you can wait.

Stability in sales will precede a decline in bloated inventories and be followed by stability in home prices.  Winter weather conditions may hold off any confirmation of an improvement until the Spring sales season -- if it arrives by then.  The seasonal adjustments will expect the normal softening over the coming quarters as the already low levels may limit the declines to leave seasonally adjusted gains.

New home sales reached an 18 year low in August and rebounded slightly in September.  Both new and existing home prices have fallen 9% from a year ago but are down -17% from their peaks.  August's 20-city home price index is released Tuesday after showing a -16% annual decline in July with a -20% drop since its peak. 

Unsold inventories have fallen off their highs but may return to higher levels if sales weaken significantly.  No sign yet of a sustainable turn in the housing sector.

 

Just Call This a Recession

Maybe next week's Q3 GDP report will swing some of the die-hards who still deny that the economy is in recession. 

The effects of the government's tax rebates and strong demand from abroad kept GDP (gross domestic product) in the positive over the first half of 2008.  A better read on domestic demand may be Q3's expected decline in gross domestic purchases after the declines in Q4 and Q2.

Yesterday's report from the Conference Board stands as still stronger evidence of the decline in activity.  The four components in the coincident index are the same used by the National Bureau of Economic Research to define the dating of recessions.  The last monthly rise in the index was in October as all four components peaked in or before January. 

 

Moreover, steady declines in housing, manufacturing, retail sales and confidence add to the steady declines in income, sales, employment and industrial production seen in the coincident index.  The economy is recessing -- duh.

The extreme measures taken by the Fed and Treasury to aid the banking, credit and capital markets speak for themselves.  The effects of the financial illiquidity will become more clear over the second half as extremely tight lending have their effect on business investment in both capital and human resources.

Our economic outlook shows negative growth over the second half of the year, weak but strengthening growth in the first half of 2009 and may not show 3%+ GDP gains until 2010.   Much of the outlook still depends on how long the financial markets (the source for business and consumer funding) remain frozen. 

Accelerated Economic Slowing

As said in Tuesday's post, extra attention should be paid to this week's retail sales and industrial production reports as they were far worse than even our dismal expectations.  Wednesday's retail sales report aided the largest decline in the Dow Industrials in 21 years.

Add the fear and wealth effects of the plunge in stock prices to the long list of consumer headwinds to explain the acceleration in the retail sales decline.  September's large -1.2% decline followed declines in both July and August and leave sales -1% below the year ago level. 

The annual declines are the largest for more costly durable goods as non-discretionary spending on food, health and general merchandise remain positive.  The -19% annual decline in vehicles tops the list as furniture is down -11% yoy and electronics/appliances and building materials have fallen more than -2% yoy.   The price driven rise in gas station sales provides an offset against the -3.5% annual fall in non-gas station retail sales.

Add steadier service spending to the retail goods spending for a fairly reliable read on overall consumer spending.   Another expected decline in inflated adjusted consumer spending -- used to calculate GDP -- will leave the last positive gain in May (thank you tax refunds !) as third quarter is expected to fall -2.5% -- the largest decline in 18 years.  With 70% weight in GDP, estimates are for a third quarter GDP decline.

Now turn to the industrial sector which produces the consumer durable goods mentioned and the more crucial business capital goods.  The -2.8% plunge in September industrial production was the largest in 34 years.   It followed a 1% August drop and flat growth in July.   The accelerated weakening leaves industrial production -4.5% from a year ago and a more shocking -8% when annualized over the last six months. 

A strike among Boeing workers and the hurricane effects on energy production provided some of the downswing but the tremendous decline was broad-based among the components and forewarned by the sharp drop in the ISM index which was noted in the Oct 7 post.

Over the last eight months industrial production only showed one month of positive growth at just 0.1% in June. 

The combined forces of declining consumer spending, residential investment and business investment is likely to trump the gains from exports and government spending in the third quarter as private domestic demand shows only a single tax refunded quarterly gain over the last year as annual growth falls in to contraction for the first time in 17 years.  If this ain't a recession, what is?  Foreign demand and Uncle Sam are the only ones contributing. 

 

A Quarter Trillion $s to Banks

Monday's 11% surge in the Dow industrials presents the positive view from the panicked stock investors of the government's decision to take a quarter trillion dollars in equity from the banking sector. 

I'll stay away from criticism about the ad hoc nature of recent "rescue" decisions and the socialist underpinnings of the government buying in to the private banking system.  Those comments probably litter the blogs.  This is the latest in a rapid series of moves to support the crumbling financial sector at any cost. 

The deal is part of the $700 bln bailout bill signed a few weeks ago and leaves half of the $250 bln equity buying in nine of the largest domestic banks as the rest will be invested among the remaining thousands.  The decision mimicked similar moves by European governments.  Seems embarrassing that the country that set this mortgage based mess spinning is now following rather than leading the attack. 

The decision to pull back on the distressed mortgage asset purchases and provide new capital are intended to get banks back actively lending and free up the frozen credit markets.  Attacking the problem in this way provides a more rapid attack on the problems in the financial sector rather than the delays involved with pricing and buying up bad mortgage debt in piecemeal.  Banks will exchange preferred shares or warrants for the needed capital.

The FDIC is expected to guarantee new debt issued by banks for the next three years further reducing investment risk and boosting capital flows. 

For those still interested in the economy, pay extra attention to this week's retail sales and industrial production reports.  Retail sales are expected to show a third month of decline as real personal consumption is expected to fall in excess of -2% in the third quarter -- the first decline since the 2001 recession and comes despite the nearly $100 bln of tax rebates provided in the second quarter.   A decline in September industrial production may exceed the -1.1% drop in August as Boeing strikers and the hurricane effects on oil production add to the weakening in capital goods exports.   Take a look at the Oct 7 post titled Add Manufacturing to the Worry List.

Everything but the Kitchen Sink

The government's efforts to calm the financial meltdown have been astounding.  Not only due to the increased frequency and creativity but the current willingness to lend to virtually anyone who runs up against a hesitant lender.  The acronyms of the plans are an alphabet soup of credit and capital stimulating plans, many of which haven't been seen since the Great Depression. 

It started in March with the Fed's TAF (term auction facility), TSLF (term securities lending facility) and PDCF (primary dealer credit facility) which failed to halt the collapse of investment banking giants Bear Stearns, Lehman Brothers and Merrill Lynch as the two remaining investment banks sought shelter by becoming bank holding companies.

The takeover of insurance giant AIG was followed by TARP (troubled asset relief program) which took over housing agencies Fannie Mae and Freddie Mac given an effort to purchase and loosen up the frozen mortgage securities assets.

The activity has gone hyper in recent weeks as the Treasury guaranteed money market mutual funds and earlier this week the Fed offered to lend directly to American corporations for the first time since the Great Depression.  The Fed's CPFF (commercial paper funding foundation) is another effort to build liquidity but has turned the Fed in to a rescuer for all as its current role seems to be to prop up private markets as well as the financial markets.

The CPFF follows an earlier Fed move to support asset-backed commercial paper (ABCP) which uses mortgage-backed securities, car or credit-card loans as collateral. 

The SPV (special-purpose vehicle) used to purchase commercial paper shouldn't be confused with the Treasury's SPFs (supplemental financing program) which allows it to issue debt, deposit the funds at the Fed which then lends those funds to banks.  The Treasury is also busy auctioning reopened coupons to raise funds either for TARP or other needs.

Today the Fed begins to offer interest on bank reserve deposits held at the Fed.  Bank requirements to hold reserves are calculated from the size of bank deposits in liquid assets.  Increased deposits are expected as the zero interest rate legislated is raised and provides some modest added funds to banks (and a stronger reason to hold them).

Yesterday's coordinated policy rate cuts from the Fed, ECB, BoE, Canada, Sweden and Switzerland was almost anti-climatic given the massive and unusual operations to date.  Yesterday's news also included U.K.'s plans to buy into large banks as Iceland is in the process of nationalizing banks.  Hopefully, there's a limit to how far the Fed will go or the Bank of America will have an entirely new meaning. 

Now the Fed's policy rate stands at 1.5%, just 50 basis points above the 1% low of the last policy easing.  Extremely low interest rates are seen as a key contributing factor to the run away credit and housing demand that started this financial meltdown.  We've come full circle.

The wonderfully strange thing about this meltdown and the attack the Fed and Treasury have mounted against it is the lack of really ugly economic data accompanying it.  Granted the stock markets are in a free fall as fear has gripped the financial markets, but the economy is pushing through with what we would call only a mild recession to date.  Obviously, the risk ahead is for a longer, deeper, darker recession if the government's battle doesn't find some traction. 

Add Manufacturing to the Worry List

While the free fall in the stock market and the financial markets crisis continues to receive top billing, recent data shows another key sector of the economy falling off -- manufacturing.

Strong foreign demand for U.S. capital goods had been keeping manufacturing somewhat insulated from the weak economy.  Last week's release of the manufacturing ISM index reflected the same downward pressures seen in actual orders and production.  

The manufacturing ISM index is a survey of purchasing managers.  It fell to a seven year low in September joined by a seven year low in production and an eight year low in new orders.  The new orders index fell nearly 10 points to 38.8 where 50 marks the difference between positive and negative growth.  The index had been below 50 for nine consecutive month but the sub-40 level really rung the warning bell.  The ISM survey components can be volatile month to month and really need to be confirmed by comparable hard data.

 

Like the new orders ISM component, durable goods orders had been rolling along flat to down since the July 2007 peak.  However, the nearly -5% August decline pulled the measure -10% from the peak as the September ISM suggests more bad news to follow.   The August decline was broad-based with metals -10%, transportation -9%, non-defense capital goods -8% and machinery -7%.  The two month decline in electrical equipment showed an -11% plunge. 

 

August industrial production showed the same sharp decline.  Overall production fell -1.1% given the -1% drop from manufacturing.  Over the last six months the decline totals to an annualized -3.5% decline.  Obviously production follows orders but the downtrend is evident here as well as the September ISM index suggests more bad news ahead.

The risk seems clear enough as manufacturing now joins the downward economic trends.  The unexpected hold out finally gave way to the credit strains and falling profits and a weakening world economy.  

Worsening Employment Trends

Friday's employment report is expected to show a payroll decline slightly larger than -100K, the largest drop of the current eight month string of declining payroll growth.  The worsening employment trends suggest a weakening in earnings, spending and economic growth.

However, the markets are riveted to the political maneuvering around the massive mortgage rescue package as more ugly employment news may not have the usually heavy weighting it carries for the markets.

The declines to date have been modest by historical standards as we've so far avoided the sharp declines seen early in the last two recessions.  In August the string of declines extended to four months for business and professional jobs as retail employment fell for a ninth consecutive month.  Declines in financial activities and construction have been uninterrupted for over a year as manufacturing shows over two year of steady declines.

The declines are broad-based as the only major components showing gains are in education, health care and government. 

 

Employment indicators are largely consistent with a larger decline in payrolls.  September's ISM manufacturing report showed a seven year low in the employment component with an 8 point decline.   The employment questions in the consumer confidence survey (the labor differential) has been falling for eight months to reach a five year low in September.  Initial claims for unemployment benefits continues to rise reaching just shy of 500K in recent weeks.  Hurricane effects added to the last few weeks as the Boeing strike and the financial ruin add  room for an even worse job count. 

 

The August unemployment rate jumped a large 0.4% to 6.1% and hasn't shown a monthly decline since April.   The measure is just 0.3% below the post 2001 recession peak and over time expected to move above it to the highest in over 15 years.