Five Things You Need to Know: FOMC Preview; Speaking of Rising Borrowing Costs; Costs Up, Productivity Down; Who's Afraid of Fannie Mae?; High-Low Index
What you need to know (and what it means)!
Minyanville's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:
1. FOMC Preview: Their Greatest Fear
How quickly things change. Barely six weeks ago on June 28, with the Dow Jones Industrial Average hovering around 13,400, the Federal Reserve Open Market Committee met and declared that their "predominant policy concern remains the risk that inflation will fail to moderate as expected."
Now, with the Dow Jones Industrial Average hovering around 13,400 level, the FOMC is supposedly meeting to... consider a rate cut? What happened? A little more than a month ago we were in such a great mood. Check out the opening salvo this morning from Bloomberg:
"A stock market slump, further declines in U.S. house prices and surging corporate borrowing costs will "shock" the economy and prompt the U.S. Federal Reserve to cut its key interest rate, according to Merrill Lynch (MER)."
Stock market slump? The Dow Jones Industrial Average is up more than 5% year-to-date, the S&P 500 has gained nearly 3.5% year-to-date and the Nasdaq Composite is leading both, so far adding 5.5% this year. What stock market slump? Over the past five years the Dow, S&P and Nasdaq are up 55%, 67% and 98% respectively. Stock market slump?
Stocks may still be up but as Professor Bennet Sedacca noted on the Minyanville Buzz and Banter this morning, financials rallied huge yesterday, but what about corporate spreads, the true barometer of the health of the financial industry? "Believe it or not, spreads on brokerage and bank corporates are actually wider than yesterday morning," Sedacca said. That means someone has it wrong. Either equity investors haven't woken up to credit market problems, or credit markets are overestimating the risk of owning corporate debt. "My guess is the credit market has it right," he said.
This explains in part why it feels so treacherous right now. If the markets have decided that too much credit is too easily available, as it appears they already have, then the Fed can simply lower rates to make credit more available. Problem solved. But what if there are two separate but related forces at work: tightening lending standards and reduced credit appetites? Then the Fed has something more serious on their hands.
The key in all of this is not inflation, as most believe. The Fed says they are most worried about inflation risks, but the reality is that they are most worried about deflation risks. Always. Always deflation. The Fed has no choice but to always remind us that the risks are tilted toward inflation, just as the Treasury Secretary, whichever one happens to be in office at the time, must always say that the U.S. maintains a strong dollar policy, even if monetary policy and fiscal policy are conspiring to devalue the dollar.
As for equities, when the dollar begins to rise, and it appears the Fed finally will begin to cut rates, as they inevitably must to try and sustain credit consumption, then it's time to worry. That means deflation is winning.
2. Speaking of Rising Borrowing Costs
An interesting article on Bloomberg this morning looks at how Texas Utilities (TXU), shopping center developer Kimco Realty (KIM) and at least eight other companies, including Tyco (TYC) and Kimberly-Clark, have agreed to pay higher interest on their debt should their credit ratings slip.
Bloomberg notes that just a couple months ago it was the borrowers dictating borrowing terms thanks to what seemed an insatiable investor appetite for corporate debt. Now, the script has flipped and creditors are becoming more demanding, dictating terms as investment grade bonds have returned 1.11% in the first seven months of this year, possibly headed for their worst year since 1999 when they lost 1.89%.
And check out this New York Times article, "Even Nonhousing Markets Feel Mortgage Fallout." The dinnerware and flatware maker Oneida was forced to withdraw a planned offering of $120 million in high-yield bonds to investors as the credit markets froze up... seemingly overnight, the Times said.
3. Costs Up, Productivity Down
Productivity rose at an annual rate of 1.8% after a downwardly revised 0.7% gain in the prior quarter that was less than previously estimated, the Labor Department reported. Meanwhile, labor costs increased at a 2.1% pace, up 4.5% year-over-year in June, the most in nearly seven years. This means we're costing the man more even though we're doing less.
Expect this report to be discussed at the FOMC meeting today; the combination of rising wages and lower productivity is not what the Fed wants. The rising employment costs are important for policy-making if they are due to cyclical inflation and economic growth. But if the underlying trend is deflationary and temporarily rising employment costs are combined with slumping productivity due to slowing economic growth, it has the potential to exacerbate the economic downturn and seep into consumer attitudes toward borrowing and consumption.
4. Who's Afraid of Fannie Mae?
Back in April we looked at how Congress was rushing to "contain housing woes." You may recall that at the time a spate of new laws were being batted around targeting investors who financed mortgage lending through mortgage-backed securities. Sounds good, on the surface - crack down on the crack dealers.
But at the time we noted that because the new laws were going to make it far more risky for investors to facilitate lenders through mortgage-backed securities, the existing pool of money available for mortgages was going to be reduced, which would raise the costs to subsequent mortgage borrowers. In an economy fueled by debt and credit creation, that's the equivalent of dropping your crack pipe down a subway grate.* The net result? A good, old-fashioned credit crunch.
Well, we got our credit crunch, but the amazing this is it happened even before Congress could get around to facilitating it. We figured that by the time Congress realized that the net result of their proposed legislation would be a full blown mortgage availability crisis, it would be time for lawmakers to step back in and, ironically having just reduced the role of Fannie Mae (FNM) and Freddie Mac (FRE) through separate legislation... expand the role of Fannie Mae and Freddie Mac to help bail us out of the crisis.
At least we got that part right.
Yesterday afternoon there was talk the Office of Federal Housing Enterprise Oversight, the GSE regulator, was actively working on ways to expand the portfolio caps that legislation this past spring reduced. Why? Because, as FNM interim chief executive Daniel Mudd and FRE Chief Executive Richard Syron explained to the Senate Banking Committee this past spring, the ability to hold onto some of those loans, and to expand them, can keep funding available in a crisis.
Sure enough, a piece on Bloomberg yesterday afternoon reported, "Fannie Mae, the largest source of money for U.S. home loans, asked its regulator for permission to take on more mortgage assets and help ease a crunch in the credit markets, a person with knowledge of the request said." Well, considering that's the same thing Fannie Mae has been saying for the past two years as legislators sought to cap their portfolios it's hardly news. Unless... unless it's not Fannie Mae doing the asking.
Who else might be asking? Politicians being pressured by banking executives who are worried about how serious the situation in credit markets has become. That would mean that in less than three months we've gone from political pressure to limit the portfolios of GSEs, to political pressure to expand the portfolio limits of the GSEs. Of course, portfolio caps also serve as profitability caps. FRE and FNM yesterday were up nearly 10% and are tacking on 3-plus% today.
So, who's afraid of Fannie Mae? Us. If these portfolio caps are raised, it would suggest credit market problems are far more serious than thought.
5. High-Low Index
Recently we looked at the oversold condition of the daily NYSE High-Low Index. Heading into today's session the NYSE High-Low Index was near 8%, its lowest level since August 2002. For a longer-term view of the NYSE High-Low Index, however, we turned to Investors Intelligence, which also tracks this index on a weekly basis.
The weekly High-Low Index reveals a starkly different picture of how "oversold" we really are. This has implications for position traders as well as those with longer-term investment time frames.
Below is the chart, courtesy of Investors Intelligence, of the weekly High-Low Index. The current level? 62.3% as of August 3. It will next be updated this Friday and will surely be lower, but 62% is far closer to overbought than oversold.
Click here to enlarge.
For comparison's sake, this index has fallen to the 30% "oversold" level just twice in the past seven years: November 2002 and July 2006.
With the daily High-Low Index at such low levels a tradable rally is probable, and any weakness surrounding the FOMC decision today is better to buy than sell.
The implications of the weekly High-Low Index, however, especially given that the broad bullish percent supply/demand indicators remain negative, are that any rallies from daily High-Low oversold conditions may be shorter-term in nature than expected.
This sets up a tradable rally for very short-term aggressive traders, but for those with longer-term timeframes it creates the opportunity to reposition portfolios, ejecting positions in weak relative strength sectors - Financials, Real Estate, Insurance, to name a few - and raising allocations in stronger relative strength sectors - Biotech, Telecom, Software.
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