THE FED AND ECONOMY. Fixed Income Commentary

Transcription

1 Fixed Income Commentary Portfolio Strategies & Analytics Group June 15, 2009 Tom Wammack Institutional Fixed Income Director Portfolio Strategies & Analytics Group (615) In this issue: The Fed and Economy The Markets Economic Releases for 6/15-6/19 Bottom Line Weekend Press THE FED AND ECONOMY Economic activity is still declining, according to the Fed s beige book, but not as rapidly as a few months ago. In most districts, contacts reported some improvement in the outlook for business activity. There was little or no improvement in manufacturing, in labor market conditions or in consumer spending from mid-april through May. There was, however, an uptick in home sales and a leveling off in home construction. Most of the sales gains were in the lower priced houses. Commercial real estate weakened further in all districts. All districts reported job losses in virtually every economic sector, and many reported reductions in wages and benefits. Labor costs are falling everywhere, and every district but one reported flat or lower retail prices. The scattered positive reports on expectations and housing activity kept this book from reading as badly as the previous two or three, but with activity still declining almost everywhere, there will almost certainly be no policy changes at the FOMC meeting next week. Retail sales increased somewhat in May, but remained weak. Even after upward revisions to the April data, sales are below the January levels. Sentiment indices have improved significantly since December-January, but that has not yet had a meaningful impact on spending. The collapse in the volume of application for refi mortgages as mortgage rates have jumped will not help consumer spending in the future. The best that can be said is that spending has stopped the freefall that made the second half of 2008 such a nightmare for retailers. Inflation indices will capture most of the attention this week. The rise in oil prices is expected to produce sizeable increases in the PPI and CPI, though the core indices should remain well behaved. Nevertheless, now that commodity prices are rising and more press articles are questioning whether inflation risks are increasing, any sizeable increases in the price indices will probably generate more concerns that the Fed is creating the potential for high inflation in 2010 and beyond. The counter argument is that inflation doesn t typically take hold when

2 Fixed Income Commentary: June 8, 2009 Page 2 of 6 economies are weak, and the housing starts and industrial production figures this week are likely to be reminders that the economy is still very soft. Starts might increase some, but will still be at near the poorest pace on record. Industrial production is expected to drop at least another 0.5%, which would be the 17 th consecutive monthly decline. The YOY drop in production is already the deepest in any postwar recession. THE MARKETS The first quarter flow of funds data released last week by the Federal Reserve show that despite the unprecedented stimulus from the Fed, there has been a very sharp decline in credit creation in the U.S. since mid In the first quarter, the annual growth rate in debt outstanding was only 4.1%, less than half the average growth rate in the five years For the second consecutive quarter, households paid down debt, something not seen before since the data start in Nonfinancial businesses also paid down debt last quarter, while financial businesses reduced debt at more than a 10% annual rate an unprecedented event. In the credit markets last quarter, only the federal government was a big borrower and only the Fed and the housing agencies were big lenders (which includes purchases of debt securities). The federal government was borrowing at a $1.5 trillion annual rate, while the financial companies were retiring debt at a $1.8 trillion annual rate. On the lending side of the ledger, the big story was again the Fed. Normally, the Fed accounts for $30 to $60 billion of the lending in the domestic credit markets. The past three quarters, that number has been in the $750 billion to $1 trillion range, as the Fed balance sheet has exploded upward. Even with this huge amount of Fed lending, however, total net lending in the credit markets was $-255 billion last quarter the first net decline on record. Borrowing by banks and other financial institutions dropped more than the federal governments borrowing increased and lending by those private institutions slowed by more than the Fed s lending increased. So, the massive amount of Fed stimulus only offset a portion of the collapse of private lending. Foreign investors, the other major group that is watched carefully, reduced their purchases of U.S. securities last quarter, but remained big buyers of Treasuries. They purchased Treasuries at a $636 billion annual rate which, while down $300 billion from the previous two quarters, was well beyond purchases in any year prior to These investors sold large amounts of MBS, agency debentures and corporate bonds and loans. The Fed and the GSEs were the only significant buyers of MBS last quarter, with the Fed acquiring these securities at a $1 trillion annual rate. Mutual funds and life insurance companies were the major institutional buyers of corporate bonds last quarter, while mutual funds and households were the principal buyers of municipal bonds. Households were also major buyers of equities last quarter but, for the third consecutive quarter, they were net sellers of large amounts of mutual fund shares.

3 Fixed Income Commentary: June 8, 2009 Page 3 of 6 FOREIGN PURCHASES OF U.S. SECURITIES, Source: Bloomberg - FRNTTOTL Index GP <GO> ECONOMIC RELEASES FOR 06/15-06/19 Date Time (CST) Indicator Prior Projected Actual 6/15 7:30 Empire Manufacturing (JUN) /15 8:00 Net Long-term TIC Flows (APR) $55.8B $57.5B 6/15 8:00 Total Net TIC Flows (APR) $23.2B - - 6/15 12:00 NAHB Housing Market Index (JUN) /16 7:30 Producer Price Index (MoM) (MAY) 0.30% 0.60% 6/16 7:30 PPI Ex Food & Energy (MoM) (MAY) 0.10% 0.10% 6/16 7:30 Producer Price Index (YoY) (MAY) -3.70% -4.40% 6/16 7:30 PPI Ex Food & Energy (YoY) (MAY) 3.40% 3.20% 6/16 7:30 Housing Starts (MAY) 458K 485K 6/16 7:30 Building Permits (MAY) 494K 498Kr 6/16 8:15 Industrial Production (MAY) -0.50% -1.00% 6/16 8:15 Capacity Utilization (MAY) 69.10% 68.40% 6/16 16:00 ABC Consumer Confidence (39978) /17 6:00 MBA Mortgage Applications (39976) -7.20% - - 6/17 7:30 Consumer Price Index (MoM) (MAY) 0.00% 0.30% 6/17 7:30 CPI Ex Food & Energy (MoM) (MAY) 0.30% 0.10% 6/17 7:30 Consumer Price Index (YoY) (MAY) -0.70% -0.90% 6/17 7:30 CPI Ex Food & Energy (YoY) (MAY) 1.90% 1.80% 6/17 7:30 CPI Core Index SA (MAY)

4 Fixed Income Commentary: June 8, 2009 Page 4 of 6 Date Time (CST) Indicator Prior Projected Actual 6/17 7:30 Consumer Price Index NSA (MAY) /17 7:30 Current Account Balance (1Q) -$132.8B -$84.8B 6/18 7:30 Initial Jobless Claims (39977) 601K 605K 6/18 7:30 Continuing Claims (39970) 6816K 6839K 6/18 9:00 Leading Indicators (MAY) 1.00% 1.00% 6/18 9:00 Philadelphia Fed. (JUN) Source: Bloomberg BOTTOM LINE Forecasts of a steep rise in inflation have proliferated recently, based on the unprecedented amount of Fed stimulus being supplied to the markets and the economy. It is important to note, however, that this stimulus, in the form of massive purchases of securities and lending to financial intermediaries, has been essentially the Fed attempting to fill the void created by the collapse in private sector lending. If one measure of excessive stimulus is excessive borrowing that promotes goods inflation or asset bubbles, this cannot be regarded as excessive stimulus. The growth in borrowing is the slowest in modern times. The Fed s activities might become inflationary if they were not scaled back as the private sector recovers. Thus far, however, the Fed s activities have probably helped prevent deflation and financial panic, but probably have not made a rise in inflation inevitable. The relatively good auction results last week suggested that the Treasury market has found yield levels that attract enough buyers to absorb the heavy volume of new notes and bonds. A 4% yield on the 10-year note appeared to remind investors that a doubling of that yield since year-end has created some value in the longer notes and bonds. The curve is now sufficiently steep that it provides a degree of protection against the eventual rise in short-term rates. If the market does not get a series of inflation scares this week, it may have found viable trading ranges for the foreseeable future. WEEKEND PRESS Barron s Bank preferred stocks prices have doubled from the lows in February-March, but the yields are still in the 8-10% range. The exception is Goldman Sachs, whose stock yields only 5.7%.

5 Fixed Income Commentary: June 8, 2009 Page 5 of 6 Moving well above the 940 level on the S&P 500 Index is proving to be a formidable hurdle. The actual range that needs to be exceeded for a new breakout is 944 to 956. A move above that range could last another 100 points. So far, the Fed has purchased $154 billion of Treasuries, $38 billion of agencies and $191 billion of MBS, a far cry from the $1 trillion they said they would buy. At the same time, the Fed s lending has been shrinking rapidly. Loans under the Term Auction Facility are down by one-third since early March. Growth in the monetary base has dropped to around a 65% annual rate from 560% late last year. Growth in M2 money is down to a 4% annual rate from 15% in the 4 th quarter of Talk about weaker foreign demand for Treasuries appears overdone. Treasuries and agencies held by the Fed for foreign institutions increased by $18 billion last week and have been increasing at a 19% annual rate. Last week, the finance minister of Japan restated his nation s confidence in Treasuries. Bill Gross finds no value in Treasuries and MBS, even after the backup in yields. He thinks there is the potential for greater inflation in Corporate and muni bonds are somewhat attractive, but he really likes hybrid preferreds. The Economist According to the IMF, by next year, the public debt of the 10 richest nations will reach 106% of GDP, up from 78% in That is $9 trillion of additional debt in three years. That ratio could reach 114% of GDP by In Japan, it is already 170%. Governments have never borrowed so much in peacetime. They have been borrowing at a strong pace in order to counter the collapse of borrowing by consumers and business. Without this borrowing, the recessions would be much deeper. Nevertheless, over the longer term, borrowing on this scale is unsustainable. The credit default swap market has noted the huge deficits by widening the spreads, but those spreads are still about half as wide as in February. An index of CDS spreads for the seven richest economies has increased from around 50 in May to around 60 now. It was around 25 in early 2008, but jumped to 125 in February. Business Week The U.S. default rate on commercial mortgages has reached 2.5%, a 15 year high. It is expected to peak at almost 5.5% in By any measure, financial markets are functioning as they were last September before Lehman collapsed. That is helping the economy to recover. The capital base of banks has improved, liquidity is deep again and investors are again willing to take risk. In recent weeks, banks have raised $75 billion in new capital. Demand for short-term funding from the Fed has dropped by $500 billion since late last year. The TED spread is down to 2007 levels. This cheaper funding means greater bank profits.

6 Fixed Income Commentary: June 8, 2009 Page 6 of 6 In the capital markets, yields on BBB corporate bonds have fallen from around 10% in November to 8% now. Spreads to Treasuries have narrowed sharply, aided by the big jump in Treasury yields this year. That is also a sign of less risk aversion among investors. Motor vehicles percentage of U.S. GDP was above 4% in the 1960s, but has dropped to around 1.5% this year. N.Y. Times Financial companies have roughly $170 billion of short term debt coming due in the next six months. Much of this debt was bought by SIVs that no longer exist, so new buyers will need to be attracted to this market. Securities lenders also invested in this debt, but they have scaled back their purchases. The FDIC will stop guaranteeing bank debt in October. Banks might face a serious challenge refunding all this debt. Stocks have gone from undervalued in March to fairly valued now, says the investment strategist at Schwab. Ned Davis Research calculates a median P/E for the S&P 500 stocks, based on operating earnings over the past 12 months. It finds a P/E of 15.6 now, up from 12 in March, but below the historical median of Institutional Fixed Income Portfolio Strategies & Analytics Group This is not a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date and are subject to change. The information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy. ADDITIONAL INFORMATION IS AVAILABLE UPON REQUEST