Inflation, Credit Concerns Weigh on Markets

MBA (6/23/2008 ) Velz, Orawin
The economy appears to continue to grow, albeit at an anemic pace, in the current quarter. The odds that it will sink into a deep downturn have diminished.
According to The Conference Board’s Index of Leading Indicators, which rose modestly in May for a second consecutive month, the economy has not contracted and may even strengthen early in 2009.

Manufacturing, which has benefited from overseas demand in the face of declining domestic demand, is not yet out of the woods. The Philadelphia Federal Reserve’s manufacturing survey showed that activity in the Fed’s District declined again in June at an accelerated pace, echoing the New York Fed’s Empire State manufacturing survey released in the prior week.

The industrial sector (factories, mines and utilities) continued to contract, as industrial production fell in May following a sharp decline in April. Although the drop in utility output was largely responsible for the overall decline in the index, manufacturing output, which accounts for about four-fifths of industrial production, was flat, as the decline in business equipment production offset an increase in auto output.

There was no relief from soaring energy and food prices at the wholesale level. Increases in these prices in May led to the biggest jump in the Producer Price Index (PPI) in six months. Outside of food and energy, the year-over-year increase in the core PPI remained historically high. The large increase in both the headline PPI and Consumer Price Index (CPI) released in the previous week seemed to justify recent hawkish rhetoric from Fed officials to attempt to keep inflation expectations under control.

The financial markets apparently believed that the Fed is poised to raise rates, fully pricing in a fed funds rate hike later this year. As a result, Treasury yields have trended up over the past several weeks, pushing mortgage rates up to the highest levels since September 2007. Rising rates have dampened demand for mortgage loans.

The Mortgage Bankers Association’s weekly survey of mortgage applications for the week ending June 13 saw another drop in total mortgage applications—the fourth decline in the past five months. Home builders saw no signs of improvement in the housing market in June. The National Association of Home Builders (NAHB)/Wells Fargo Housing Market Index—a measure of home builders’ confidence—declined in June, matching the record low reached in December 2007.

Without signs of a significant pickup in housing demand and elevated inventory of homes available for sale, it remains necessary for home builders to continue to pare back housing starts, which fell 3.3 percent in May. Single-family starts dropped for the 14th consecutive month, putting year-to-date single-family homebuilding 40.1 percent lower than those in the first five months of 2007. By contrast, year-to-date starts of 5-units-and-over were 15.7 percent higher than those last year.

Treasury yields were volatile last week. The Treasury markets rallied and yields moved lower by Wednesday as investors sought safe havens from the declining stock markets. Financial stocks fell after Goldman Sachs Group Inc. warned of further losses in the credit market and estimated that U.S. banks must raise as much as $65 billion in new capital. On Thursday, yields reversed the drop as stock prices rose in response to an unexpected increase in The Conference Board’s Index of Leading Indicators.

On Friday, rising crude-oil futures for July delivery to nearly $136 a barrel and concerns of further credit-related losses pushed stocks sharply lower toward the lows seen in mid-March. Financial worries included an ‘AAA’ ratings cut by Moody's Investors Service of bond issuers MBIA Inc. and Ambac Financial Group Inc. on worries about further mortgage-related writedowns. The yield on 10-year Treasury notes stayed around 4.14 percent by mid-Friday afternoon, 13 basis points lower than the rate on the previous Friday.

The financial markets largely expected the Fed to leave interest rates unchanged at the Federal Open Market Committee meeting on June 24-25. However, Fed funds futures fully priced in a rate hike by the end of September. Given continued slowing housing and manufacturing activity and renewed credit concerns, an early rate hike appeared less likely than the odds implied by the fed funds futures.