The Fed Makes Its Move

The Fed's newfound economic optimism comes at a time when things are looking a little softer to me.

Robert Johnson, CFA 08.07.2013
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The Federal Reserve almost entirely drove the markets this week. Fed statements and a news conference suggested that the economy was stronger than it previously thought, and as a direct result, bond purchases could cease sooner than anticipated, perhaps by the middle of 2014. That sent bonds plunging, which makes sense, and equities too, which makes somewhat less sense, except perhaps as a knee-jerk reaction and the potential for more competition from higher-yielding bonds for stocks.

U.S. economic news was mixed, with good news matching bad news tit for tat. Builder sentiment was up sharply, but housing starts and permits were lethargic. Existing-home sales were showing signs of breaking out, but initial unemployment claims ticked up. Weekly shopping center data dipped again, but the Empire State manufacturing data looked a little better. Inflation data remained remarkably moderate, with health-care costs (notably, and perhaps inexplicably) tame. Inflation is now running under Fed targets.

World Data, Especially China, Look Weaker
However, world data was much less benign and probably at least partially behind the poor performance for equities. Particularly worrisome was news out of China that its manufacturing economy continues to slip, which has knock-on effects in neighboring countries, commodity-oriented economies, and other emerging markets.

Slowing world trade, while not the key driver of  FedEx's (FDX) disappointing report, confirms that world trade is certainly not booming and at a minimum, slower demand is forcing shippers to find cheaper alternatives. Frankly, the Fed's newfound economic optimism comes at a time when things are looking a little softer to me. Maybe the tapering doesn't happen as soon as the Fed is currently contemplating. But that will just delay the inevitable end of Fed easing.

Fed Raises Economic Forecasts, Lays Out Potential Cessation of Bond Purchases
This week, the Fed made its intentions just a little clearer concerning mortgage bonds, Treasury bonds, and its setting of short-term interest rates. It also released its economic forecasts that underpinned its decisions. While making some of its targets a little sharper, all of its maneuvers remain dependent on economic improvement. Nothing that Fed chairman Ben Bernanke said is cast in stone. If the economy weakened, all bets are off and even more easing is a possibility.

The proximate cause of all the market gyrations was Bernanke's news conference remarks noting that all bond-buying programs, which depress interest and mortgage rates, could be cut back as early as this year and could be eliminated as early as the middle of 2014--if the economy tracks Fed forecasts and the unemployment rate is around 7%. This is not a complete surprise given a strengthening economy, past Fed statements, and subtle hints dropped into Fed member speeches over the last month or two. Fed plans for short-term interest rates are a completely separate issue, and the Fed foresees little change until 2015. The Fed's current statements are extremely consistent with its past remarks indicating that if the economy improved, it would withdraw support.

Tempering the news a little was the Fed's announcement of plans to hold any bonds it currently holds indefinitely; they would not be dumped on the market willy-nilly. Furthermore, all dividends and mortgage repayments received on current holdings would be reinvested in full--policies that in a shrinking market for debt are still quite expansionary. Bernanke characterized this as easing up on the accelerator and not stepping on the brakes.

Fed Economic Forecast Remarkably--Unbelievably--Upbeat
I suppose the only real surprise is that the Fed outlook for the economy is remarkably more bullish--too much so, in my mind. Its forecast for 2013 GDP growth is 2.3%-2.5% compared with my forecast of 2.0%-2.25%. For 2014 it is even more bullish, estimating 3.0%-3.5% growth compared with my forecast of 2.0%-2.5%. The Fed also lowered its inflation forecast and significantly lowered its expectations for the unemployment rate, one of the announced key drivers of Fed policy.

Its economic optimism (according to news conference statements) is based on better employment news, higher home prices, and consumer confidence polls (yuck--not a good forecasting tool, in my opinion). Ultimately, I think its optimism is a little misplaced, and the tapering may happen a little later than sooner. Interest rates were clearly and artificially too low, and probably still are.

Interest Rate Adjustment May Not Be Complete
While in my mind there wasn't that much new in the statement, it was an emperor-has-no-clothes moment for the market, which suddenly seemed to realize that rates were too low. Interest rates are ultimately a function of expected inflation rates and a premium for not spending one's cash. Generally that premium is larger the longer the maturity of that bond. Typically that spread over inflation has averaged 2.0%-2.5% for 10-year U.S. Treasuries (but exhibiting wild short-term swings). Even with inflation at 1.0%-1.5%, that suggests that the 10-year Treasury bond should carry a rate of 3.0%-3.5%. Fed actions and nudges, a slow economy, and restrained credit demand in some combination caused that rate to dip as low as 1.4% over a year ago. It rebounded to about 1.7% at the beginning of 2013 and after the Fed announcement, and stands at 2.4% as of Friday morning.

Not in a straight line, but interest rates still need to move higher and bond prices need to be lower. Maybe it happens Monday, maybe it happens a year from now, but rates still don't reflect normal economic realities. And the prices of bonds still have more room to go down. However, equities are an entirely different story, especially if the economy picks up as much as the Fed suggests. While higher bond rates could provide a little more competition for equities, newfound bond market volatility may drive away some retail buyers who now may consider more growth-oriented equities.

Existing-Home Sales Provide an Upside Surprise
As I anticipated last week, existing-home sales provided an upside surprise as foreshadowed by an improved pending home sales report several weeks earlier. Single month home sales, seasonally adjusted and annualized, hit 5.18 million units, their best reading since 2009. That was nicely above April's 4.97 million result and consensus estimates of just 5.0 million units. The year-over-year unit growth improved modestly and the little-mentioned transaction dollar values accelerated slightly, driven by higher prices in addition to better unit sales.

While the data didn't exactly power out of their respective ruts, it is nice to see at least a little acceleration, even if it doesn't qualify for full-fledged breakout status. The housing market will remain an able contributor to GDP growth in the second quarter, perhaps even accelerating from fourth-quarter levels.

Home Inventories Up, But Not Up Enough
Absolute housing inventory levels moved up and the year-over-year decline rate in inventories has at last begun to moderate. However, inventories are still down 14% from a year ago on a moving-average basis, which is why prices continue to accelerate. More demand and less supply continue to drive prices. While inventories have moved up slightly, the recent month-to-month improvements still aren't enough to cause a sharp acceleration in existing-home sales, in my opinion. Also, keep in mind that inventory data is not seasonally adjusted and usually moves up during the spring and early summer months.

Housing Starts and Permits Not as Robust as Hoped
While existing-home sales data showed some acceleration, housing starts and permits looked a little soft, at least relative to expectations. Given a choice between great housing starts and great existing-home sales, new starts wins hands down. New starts create more jobs than merely selling a new home. In the GDP calculation the full value of a home is included. For an existing home, only the brokerage commission is included in GDP. The housing starts growth rate is clearly slowing at the moment.

Single-family data looks a little weaker than the multifamily/apartment sector. Certainly 28% year-over-year growth is no disaster, but the trend is not pretty. Unfortunately, permits, which generally lead housing start growth rates, are falling even faster and have exceeded start growth rates for several months. That bodes poorly for any rapid acceleration in housing starts in the months ahead.

Inflation Under Control, Not Too Low Just Yet
It seems like it was just a few short months that everyone was worried about inflation and its detrimental effects on the economy. With gasoline and food prices finally slowing up, the headline inflation numbers have come in quite dramatically even on a year-over-year averaged basis, as shown below.

The sharp drop-off has caught everyone's attention, including the Federal Reserve. Bernanke, in the news conference, noted that inflation had fallen below the Fed's 2% target. He wasn't panicked just yet because he thought energy and certain health-care categories were artificially depressing the metric for now, and higher rates of inflation are likely in the months ahead. That didn't stop one Fed governor from voting against the current policy statement. He believed further loosening was in order because inflation fell below the official target for too long and by too much.


I tend to agree with Bernanke, that the inflation rate is bound to rise a bit in the months ahead, but certainly not dramatically. The mix of inflationary items shows that there is a healthy balance of things going up and moving down in price.

The output gap, commodity prices, and fiscal policy are arguing for continued low prices in the U.S. with only monetary policy being modestly inflationary. For the moment deflation seems to be a bigger worry than inflation. However, a category-by-category review shows that prices are nowhere near a uniform drop, let alone a freefall. Positive energy price news seems destined to come to an end as it already has for natural gas and electricity. The declines in health-care prices seem unsustainably low as well.

U.S. Manufacturing Data the Best of a Bad Litter
World manufacturing data has been under a lot of pressure in 2013 as the commodities slump and poor auto shipments in many parts of the world weight the data heavily. The China Markit Purchasing Managers Index manufacturing data has been particularly disappointing and that trend intensified in June as the PMI was not only below 50, but also declined from the previous month, as shown below. Economists are racing yet again to reduce their GDP forecasts for China that have fallen from over 8% to just over 7% over the past couple of months. A modest slump in the manufacturing economy isn't a big deal to the U.S. economy but is bad news for China's export-driven economy. (There were additional issues this week in the Chinese lending market that won't be helpful for economic growth, either.)

The European data managed a small increase but remained below 50, which means more firms saw decreases in business instead of increases. The U.S. data remained basically unchanged, but in growth mode, driven largely by strong results in autos and civilian aerospace.

Consumer Spending Data Lead Next Week's Data Parade
The news for next week is relatively thin and primarily real estate-related. On the home sector front, Case-Shiller home prices, pending home sales, and new home sales are all due next week. In addition, the personal income and consumption report will be released along with the third and final version of first-quarter GDP estimates. Of all these reports, the personal consumption report will probably be the most important, as the consumer drives 70% of U.S. economic activity. However, the consumption report is always just a little dated, because it represents data from May. Other key economic data to be released three or four days later will be for June.

Expectations are for a continued slow improvement in consumer spending with no big bounce anywhere in sight. Consumer spending is expected to be up 0.2% (2.4% annualized) for May after dropping 0.2% in April. The reported monthly consumption numbers that the media fixates on have been a real yo-yo, ranging from 0.8% to negative 0.2%. However, stripping out the effects of inflation, the results are in a much tamer range of 0.1%-0.4% for the same period. And the inflation-adjusted consumption data becomes even more tightly packed when looked at on a year-over-year, averaged basis, with growth of 1.85%-2.1% over the last five months. That range is unlikely to be broken in May, based on retail sales reports and weekly shopping center data that we have seen thus far. This stable level of consumer spending is likely to keep a lid and a floor on overall economic growth in the 2% range. I suspect that consumption for the full second quarter annualized will be about 2%, down from the Hurricane Sandy rebound-aided 3.4% growth rate of the first quarter. The retail data we have already seen thus far plus an ongoing hangover from the payroll tax increase suggest that a new boom is not just around the corner, but no plunge is evident, either.

I am very interested in the pending home sales report as it is often a good indicator of the more closely watched existing-home sales report. As discussed in this week's existing-home sales analysis, pending home sales successfully predicted the improvement in existing-home sales. With fear of impending rate increases closing in, I suspect some homebuying fence-sitters may have been pushed into action in the last month or two as mortgage rates jumped to over 4% again. This just might give the housing industry a short-term boost, but could slow things a bit later on this year.

Will Home Prices Continue to Accelerate?
Home prices have taken on just a little more significance; in his most recent news conference, Bernanke cited higher home prices as one of his key reasons for optimism on the U.S. economy. While the Case-Shiller data on home prices is likely to impress, I caution that it is old news. The data released will be for the period ended way back in April. Based on  CoreLogic (CLGX) data released much earlier this month, it would appear highly likely that the Case-Shiller price index will meet or exceed the 10.9% year-over-year growth rate it achieved for the period ended in March. The much mellower (in both directions) Federal Housing Finance Administration is also expected to show continued improvement. As much as we like all this good news, I do caution that not all markets are doing equally well, with strength concentrated in markets that took a drubbing during the recession and along the West Coast. Leveraged buyout firm activity is clearly helping along a relatively small number of markets in a big way

New Home Sales: Will the Breakout Continue?
The new home sales report is always a little tricky to analyze because it includes both homes still on the drawing board and homes already completely finished. Also, it includes only single-family homes and excludes apartments and custom-built homes. That said, new home sales data looked like it has been trying to break out of it rut and has shown signs of improvement, unlike housing starts and permits that are showing signs of plateauing. New home sales had been running below 400,000 units in 2012 and edged up to the 454,000 level in the April report. Expectations are for sales to inch up to 463,000 units for April.

Robert Johnson, CFA, is director of economic analysis with Morningstar.


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Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis with Morningstar.

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