Prieur Perspective: Inflation Fears and Rate Hikes
Hawkish comments marked a cautious week.
The Electric Light Orchestra lyrics to Livin' Thing ("You took me ohh, higher and higher baby, it's a living thing, it's a terrible thing...") have been mulling through my head over the past week as central bankers' inflation-fighting rhetoric moved to centre stage.
A succession of hawkish comments from U.S. policymakers persuaded pundits that the U.S. rate-cutting cycle was over, resulting in a stronger U.S. dollar, plummeting government bonds, predominantly lower global stock markets (with Asia seeing the most red), and non-agricultural commodities coming off the boil.
Ben Bernanke, Chairman of the Federal Reserve, said on Monday that the danger of a "substantial downturn" in the U.S. economy had abated during the past month but that inflation risks were growing.
A flood of similar comments from other Fed officials followed, all of which seemed to emphasize concerns about keeping inflation expectations in check, with some making specific reference to the need for a stronger dollar to temper inflation.
In addition to Bernanke, the line-up of Fed speakers included Vice Chairman Kohn, New York Fed President Geithner, Dallas Fed President Fisher and Philadelphia Fed President Plosser. The latter two Fed members have been the biggest inflation hawks at the Fed, having dissented at recent FOMC meetings on either the need to cut rates or the quantum of rate cuts.
Although a rate hike by the Fed isn't a fait accompli, it was widely accepted that the commentary was a clear indication that the Fed was at least done with cutting rates.
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Foreclosure filings last month were 48% higher compared with a year ago, according to RealtyTrac. This reminds me of the following e-mail I received from a reader last week:
"My daughter has a social club for singles in a "U.S. Big City." She heard members talking about not paying their mortgage payments because it takes ten months for the banks to foreclose and their condo/house (with no money down) is worth much less than what they "paid" for it. This way they can save $10,000 to $15,000 before they have to move... This may not be about being able to afford the mortgage. Many home prices have dropped by 25% in the "US Big City"!"
What can one say? In the words of Jeff Saut, Chief Investment Strategist of Raymond James: "Sometimes me sits and thinks and sometimes me just sits! Manifestly, It's a Mad, Mad, Mad, Mad World!"
Now, let's briefly review the financial markets' movements on the basis of economic statistics and a performance round-up.
The tone of the most recent U.S. Beige Book was of weaker growth, with the collection of anecdotes noting that "economic activity remained generally weak in late-April and May." The report was consistent with greater inflation risk from rising prices for energy and other commodities.
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The U.S. Consumer Price Index showed an increase of 0.6% in May and 4.2% compared to May 2007. As expected, the largest single increase was in energy prices and food prices, which increased by 17.4% and 5.1% respectively from a year ago.
Still on the inflation front, the U.S. Import Price Index rose by 2.3% in May, led by petroleum prices, which rose 7.8% and were up 68.8% over the year. The increase in import prices was larger than expected and bolstered the case for the Fed to end monetary easing.
Fed funds futures are now pricing in a 100% chance that the Fed will raise rates by 50 basis points at the October meeting, while there is a 24% chance of a 75 basis point increase. As far as the January meeting is concerned, the futures are pricing in a 98% chance of rates increasing by 100 basis points to 3%.
Paul Kasriel, chief economist of Northern Trust, sees the rate situation as follows:
"Fed rhetoric will continue to lean on the hawkish side until the June 24 and 25 FOMC meeting. A 2.0% Federal funds rate is the most likely case for the outcome of this meeting. The appreciation of the dollar since Bernanke's comments on June 9 suggests that open mouth policy is working. However, action might be necessary because talk tends to lose power if it is not backed by action eventually.
"Will the Fed tighten monetary policy in the absence of improving economic conditions to contain inflation and support the dollar? It is conceivable the Fed could engage in a one-off 25 basis point hike in the funds rate, which could not make a material difference on business activity because the Fed has taken radical preemptive action as an insurance against the possibility of a severe economic downturn and/or continued financial market disruptions."
Inflation also remains the major bugbear in other parts of the world. Examples include U.K. producer price growth staying elevated, with PPI and import prices rising by a record 8.9% and 12.7% respectively from a year ago, and German consumer price inflation accelerating to 3.0% in year-ago terms.
Although the European Central Bank moved to damp down market expectations of a flurry of interest rate increases in the coming months after Jean-Claude Trichet's statement of the previous week, bank officials' tone was still decidedly hawkish.
The Bank of Japan left the overnight call rate target at 0.5% in the face of Japanese consumer confidence falling to a six and a half year low.
Here are this week's economic reports, courtesy of Yahoo Finance, June 13, 2008.
The next week's economic highlights, courtesy of Northern Trust, include the following:
1) Producer Price Index (June 17): The Producer Price Index for Finished Goods is expected to have risen 0.8% in May, reflecting higher food and energy prices. The core PPI is most likely to have moved up 0.2% after the 0.4% increase seen in April. Consensus: +1.0%, core PPI +0.2%.
2) Housing Starts (June 17): Permit extensions for new single-family and multi-family homes advanced in April. However, the large stock of unsold new homes suggests builders could be reluctant to break ground as yet, with housing starts projected to have declined to an annual rate of 970 000 from 1.032 million in April. Consensus: 980 000.
3) Industrial Production (June 17): The manufacturing man-hours index declined 0.2% in May, which is indicative of a reduction in industrial production in May after a 0.7% drop in April. Consensus: 0.1%; Capacity Utilization: 79.7 versus 79.7 in April.
4) Leading Indicators (June 19): Interest rate spread and stock prices are the only two components likely to make a positive contribution in May. Initial jobless claims, consumer expectations, vendor deliveries, and real money supply are expected to make negative contributions. Forecasts of money supply and orders of consumer durables and non-defence capital goods are used in the initial estimate. The manufacturing workweek held steady in May. The net impact is a steady reading of the leading index after a 0.1% increase in April. Consensus: 0.0%
5) Other reports: NAHB Survey (June 16), Current Account Q1 (June 17), Philadelphia Fed Survey (June 19).
This performance chart from the Wall Street Journal Online, June 15, shows how different global markets performed during the past week.
The MSCI World Index dropped by 2.9% during the past week as concerns about inflation and hawkish central comments gathered momentum, with emerging markets (-5.3%) bearing the brunt of the declines.
Asian stock markets, in particular, suffered big losses, for example: the Chinese Shanghai Composite Index (SCI) (-13.8%), the Hong Kong Hang Seng Index (-7.4%), the Taiwanese Weighted Index (-7.3), the South Korean Kospi Index (-4.6%) and the Japanese Nikkei 225 Average (-3.6%).
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The Shanghai Composite Index has slumped by 52.9% since its high of October 2007 on concerns that measures to keep price increases in check will erode corporate earnings. This rout helped to narrow the price-earnings gap between the Shanghai Composite Index and the S&P 500 Index to 3.1% from 127% at the beginning of 2008, according to data compiled by Bloomberg.
Thanks to a solid close-of-week rally, the U.S. stock markets fared relatively well, as shown by the past week's index movements: Dow Jones Industrial Index +0.8% (YTD -7.2%), S&P 500 Index 0% (YTD -7.4%), Nasdaq Composite Index -0.8% (YTD -7.5%) and Russell 2000 Index -0.9% (YTD -4.3%).
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The beleaguered Philadelphia Bank Index edged up on Thursday and Friday to close the week down by 4.3%, with embattled Lehman Brothers (LEH) – plunging by -20.1% for the week notwithstanding a 13.7% gain on Friday – weighing heavily on the performance of the financial sector.
The Dow Jones Industrial Index and the S&P 500 Index remain below both their 50- and 200-day moving averages, but the Nasdaq Composite Index and Russell 2000 Index succeeded in creeping back to above their 50-day moving averages (although still below the key 200-day line). Importantly, all the major U.S. indices managed to survive another week above their March lows.
I penned some thoughts on the U.S. stock market, including a few interesting charts, in a post a few days ago. Here is the link: Stock Market: Up, Down, Sideways?
Government bonds got dumped as the yield curve adjusted to shifting expectations about the timing of a possible interest rate hike by the Fed.
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The front end of the Treasury yield curve, being the most sensitive to Fed policy moves, sold off sharply with the yield on the two-year Note spiking by 64 basis points during the week to close at 3.04%. The yield on the ten-year Note, which is more sensitive to inflation pressures, rose by 32 basis points to 4.26%.
As far as the rest of the world is concerned, short-dated bond yields were mostly significantly higher. For example, the yield on the U.K. two-year Gilt jumped by 40 basis points to 5.45%, whereas Japanese two-year yields surged by 11 basis points to 1.0%.
U.S. mortgage rates also increased sharply, with the 15-year fixed rate rising by 24 basis points to 6.00% and the 5-year ARM 39 basis points higher at 5.87%.
Credit market stress increased as shown by the widening spreads of both the CDX (North American, investment grade) Index and the Markit iTraxx Europe Crossover Index.
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The pick-up in expectations of U.S. interest rate hikes triggered an impressive 2.4% rally in the U.S. Dollar Index to its highest level in three and a half months and its best weekly performance since January 2005. The greenback also benefited from pundits' belief that the U.S. would use the weekend's G8 meeting to mobilize support for the currency.
The dollar gained 2.9% against the Japanese yen, 2.6% against the Swiss Franc, 1.1% against the British pound and 2.5% against the euro. The Eurozone currency corrected sharply on Irish voters' rejection of the European Union's new reform treaty – a repeat of three years ago when the Dutch and French condemned the original constitution.
John Mauldin (Thoughts from the Frontline) commented as follows: "Six years ago I talked about the euro rising to $1.50, but I also noted that by the middle of the next decade it is likely to come back to par. We are halfway on that journey, and I still think we will arrive at my predicted point. I think it is possible that the dollar could rise 10% or more this year against the euro, which would help inflationary pressures."
The U.S. dollar's gain impacted negatively on commodity prices, particularly crude oil which ended a volatile week 2.2% lower at $135.5 per barrel. Gold bullion and other precious metals suffered the same fate.
However, gains in agricultural commodities, following the flooding in the U.S. Midwest, pushed the Reuters/Jeffries CRB (+1.0%) to an all-time high. Both corn (+13.3%) and soyabeans (+7.8%%) set new records, whereas wheat (+10.1%) also moved up strongly on concerns about this year's U.S. crop. Separately, cocoa (+3.7%) climbed to a 28-year high due to a lack of rain in Ghana and the Ivory Coast.
The chart below shows the past week's performance of the various commodities.
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