Big Doses of Stimulus in the Pipeline

MBA (3/24/2008 ) Velz, Orawin
The Federal Reserve was aggressive and creative last week in providing liquidity to financial institutions. The actions started on March 16, when, for the first time, the Fed established a Primary Dealer Credit Facility (PDCF), offering overnight loans through its discount window to primary dealers (including major investment banks).
Until now, the access for cash through the discount window was only open to depository institutions with reserve accounts at the Fed. The Fed facility allows a wide range of collateral, including investment-grade corporate securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available. Essentially, the PDCF provides primary dealers the access to cash using illiquid mortgage assets as collateral. The PDCF appeared to calm the markets as it should help reduce the odds of another liquidity crisis at investment banks following the Bear Stearns’ problems.

On Tuesday, the Fed cut the fed funds rate by 75 basis points to 2.25 percent. In effect, the Fed has reduced the funds rate 300 basis points between last September and March of this year. The last time we saw such an aggressive cut (from 5.25 percent to 2.25 percent or a 57.1 percent cut) was between April and November 2001 (from 4.5 percent to 2.0 percent, a 56.5 percent cut), in the midst of the previous recession.

On Wednesday, the Bush administration reduced the amount of capital Fannie Mae and Freddie Mac are required to hold, allowing them to buy or guarantee more mortgages. At the same time Fannie Mae and Freddie Mac agreed to raise more capital (perhaps through stock offerings) providing assurances that capital levels will exceed requirements.

On Thursday, the New York Fed announced a modification to the new Term Securities Lending Facility. The TSLF allows primary dealers to obtain Treasury securities (not cash) for 28 days in exchange for a broader set of assets. When the Fed introduced the program on March 11, eligible collateral included agency debt, agency residential mortgage-backed securities (RMBS) and AAA private-label RMBS. The TSLF auctions (the first one will be held on March 27) will allow agency collateralized mortgage obligations and top-rated commercial mortgage-backed securities (CMBS) as collateral.

These efforts should help provide liquidity in the market for mortgage-backed securities. With added liquidity, the spread between mortgage rates and the benchmarked 10-year Treasury yield should narrow, spurring demand for home purchase and refinancing. We have seen some improvement over the past few days. For example, yields on Fannie- and Freddie-backed securities have fallen sharply, as investors’ appetite for mortgage-backed securities have increased. Still, credit spreads for mortgages and other assets, albeit narrowing, are far wider from historical norms.

In contrast to the improving financial market developments, economic news continued to signal stalling economic growth. Home builders’ confidence was stuck near record lows. Single-family starts declined for the 11th consecutive month and have now reached the lowest level since January 1991. Total permits—a forward-looking indicator—posted the largest decline since January 1991, and, for the first time since November 1991, they fell below the one million unit mark. Industrial production fell sharply and The Conference Board’s Index of Leading Indicators dropped for the fifth consecutive month. Initial jobless claims and continuing claims both suggest that nonfarm employment will likely post the third consecutive decline in March. Finally, regional Federal Reserve Banks’ manufacturing surveys showed declining activities consistent with levels seen in the previous recession.

Long-term Treasury yields declined for the fourth consecutive week. The stock markets rallied on Tuesday before the FOMC meeting, helped by better than expected earnings from Lehman Brothers Holdings Inc. and Goldman Sachs Group Inc., alleviating credit concern following the Bear Stearns’ crisis. Treasury yields increased as funds moved from Treasuries to stocks. The yield on the 10-year Treasury note jumped 15 basis points higher than the closing rate on Monday. Yields reversed on Wednesday as the stock markets reversed some of the big rally on Tuesday and remained low through the rest of the week. The 10-year yield was 3.33 percent on Friday 11 basis points lower than the closing rate on the previous Friday.

Federal Open Market Committee
The FOMC cut the federal funds rate 75 basis points to 2.25 percent, following a 50 basis point cut on January 30. The rate is now at the lowest level since February 2005.

In the post-meeting statement the committee acknowledged that economic activity, including consumer spending and employment, has softened further. It noted that financial markets are under “considerable stress.” Tight credit conditions and further decline in the housing market will continued to weigh on growth over the “next few quarters.”

The committee paid more attention to inflation than it did in previous statements. It noted that inflation expectations have risen. While the FOMC expects inflation to moderate, it argued that inflation outlook has become more uncertain. Despite the discussion on inflation, the committee acknowledged the downside risks to growth, keeping the door open for additional cuts in April.

The fed funds rate cut decision was not unanimous. Dallas Fed President Richard Fisher and Philadelphia President Charles Plosser voted for a smaller cut. This is the second consecutive meeting that Fisher dissented and the first time that there have been two dissenting votes during Fed Chairman Bernanke’s time. The Fed also lowered the discount rate by 75 basis points to 2.50 percent.

Housing and Mortgage Indicators
The National Association of Home Builders/Wells Fargo Housing Market Index remained at 20 in March, two points above the record low of 18 reached in December. (A value of less than 50 indicates that more builders view the market as unfavorable.)

The survey asks builders for their sentiment about current sales, traffic of potential buyers and projected sales over the next six months. Both the indices gauging current sales conditions and traffic of prospective buyers were unchanged at 20 and 19, respectively. The index gauging sales expectations for the next six months edged down one point to 26. Builders reported that potential buyers are either reluctant to purchase or they are unable to qualify for a mortgage.

Total housing starts edged down 0.6 percent in February to a seasonally adjusted annualized rate (SAAR) of 1.065 million. Single-family starts fell 6.7 percent. Multifamily starts were up 14.4 percent, following a 43.6 percent surge in January (an upward revision from an initial report of 22 percent gain). Both starts of 5-and-over units and 2-4 units rose 14.5 percent and 12.5 percent, respectively.

Permits fell 7.8 percent in February to 978,000 units (SAAR). Single-family permits dropped 6.2 percent. This marks the 11th consecutive monthly decline in single-family permits, which reached the lowest level since January 1991.

Regional performance varied significantly. Total housing starts dropped sharply in the Northeast (27.7 percent). They increased in the South (3.9 percent) and the West (5.1 percent) and flat in the Midwest.

Through the first two months of this year, single-family starts were 38.9 percent lower than those in the first two months of 2007. By contrast, multifamily starts for the first two months of 2008 were 17.1 percent higher than those last year.

While both single-family and multifamily construction declined during the current housing downturn, multifamily home building’s drop has been much more moderate. Since the peak in January 2006, single-family housing starts have declined 62 percent, compared with a 21 percent drop for multifamily starts.

The Mortgage Bankers Association Weekly Survey of Mortgage Applications for the week ending March 14 showed that mortgage demand decreased. This is the fifth drop in six weeks. The Market Index was down 2.9 percent to 652.0, as both the Purchase and the Refinance indices fell 1.0 percent and 4.6 percent, respectively.

The 30-year fixed mortgage rate fell 39 basis points to 5.98 percent—completely offsetting the surge in the previous week. The one-year adjustable rate rose an additional 23 basis points to 6.95 percent, following an 89 basis point surge during the previous week.

The ARM share of mortgage applications of the number of loans plunged dropped 7.6 percentage points to 7.9 percent. The share of the dollar volume of new applications fell about 10 percentage points to 19.3 percent.

Economic Indicators:
Industrial production—a measure of the nation’s output at factories, mines and utilities—fell 0.5 percent in February. This is the largest drop since October 2007. The decline followed a 0.1 percent increase in January.

Manufacturing output dropped 0.2 percent, also the largest decline since October. Utility output fell sharply by 3.7 percent, accounting for about half the decline in overall industrial production. This is the biggest decline since March 2006. Mining output rose 0.4 percent, partially reversing a 1.3 percent decline in January.

The industrial production report showed that capacity utilization—which measures a portion of plants in use and thus a gauge for inflation pressures—dropped from 81.5 percent in January to 80.9 percent, the first reading below 80 percent since November 2005.

Capacity utilization has fallen in five of the past seven months and is now 1.5 percentage points below its recent peak in the summer of 2006. The rate averaged 79.6 percent over the past five years.

The decline in manufacturing output corroborates the drop in the Institute for Survey Management (ISM) manufacturing index. The ISM manufacturing index fell to 48.3 in February, the lowest reading since April 2003 and the second reading below 50 (indicating reduced manufacturing activity) in the past three months.

The Producer Price Index (PPI) rose 0.3 percent in February, following a 1.0 percent increase in January. Excluding the volatile food and energy items, the core PPI rose 0.5 percent in February, the biggest increase since November 2006. From a year ago, the core PPI was up 2.5 percent, accelerating from 2.4 percent.

The Conference Board’s Index of Leading Indicators, a gauge of future business activity three to six months ahead, fell 0.3 percent in February, following a 0.4 drop in January (previously reported as a 0.2 percent drop). The index has fallen for five consecutive months. The last time the index declined for this long was in early 2001, as the economy entered a recession. The 0.3 percent decline puts the index at its lowest level since September 2005, when consumer confidence plummeted following the surge in energy prices as a result of Hurricane Katrina. According to The Conference Board, economy growth will be weak this spring and a small economic contraction is possible.

Initial unemployment claims—one of the 10 indicators making up the index of leading indicators—increased 22,000 to 378,000 for the week ending March 15. This is the highest reading since early October 2007. The Labor Department noted that the claims may have been affected by an auto industry strike that shut down several plants across the Midwest. The four-week moving average also continues to trend up to the highest reading since October 2005.

Continuing claims, which gauge the pace of hiring rather than layoffs, increased 32,000 to 2.865 million for the week ending March 8. This is the highest level since August 2004. Recent trends in continuing claims suggest that businesses have been reluctant to hire retrenched further, suggesting that employment in March may be weak again.

The New York Federal Reserve’s Empire State Manufacturing Survey showed reduced manufacturing activity in the region. The index fell 10.5 points to minus 22.2, the lowest reading since the series' inception in July 2001. A reading below zero indicates a contraction in the manufacturing sector in the region. The index was 2.6 points below the previous record low in November 2001, when the economy was in a recession.

The Philadelphia Federal Reserve Manufacturing Survey showed that the area’s manufacturing sector continued to struggle, as activity declined again in March but at a more moderate pace. The general business index was up 6.6 points to a minus 17.4 in March. (Readings below zero indicate contraction.) Manufacturing in the Philadelphia region contracted for the fourth consecutive month. The last time the index showed negative readings for that long was in 2003.

This Week:

• Monday—February existing home sales;
• Tuesday—The Conference Board’s Survey of Consumer Confidence and Standard and Poor’s Case-Shiller House Price Indices;
• Wednesday—February durable goods orders and February new home sales;
• Thursday—The final estimate of fourth quarter gross domestic product;
• Friday—February personal income & personal consumption expenditures and the University of Michigan’s Survey of Consumer Sentiment for March.