The Week Ahead: Fed Cuts and Bank Failures

Despite the news from Bear Stearns and a weak retail sales report, the Dow actually ended the week up 0.48%. Nonetheless, there isn’t much else to boast about; the NASDAQ ended unchanged while the S&P500 lost 0.40%. However, the CPI release surprised the market by coming in well below expectations and showing no increase for either the core or headline indices. This development was mostly sidelined by the problems at Bear.

But looking forward; this week it’s all about the Fed. Despite the encouraging CPI report the Fed will not view one month’s data as the beginning of a trend; they will remain very vigilant over inflation. However, the news from Bear Stearns and growing trouble in the financial sector will cause the Fed to cut rates by 75bps. We do not believe the Fed will move a total of 100bps given their current concerns over inflation. If the Fed was to move a total of 50bps verses 75bps and the market reacted adversely it would potentially open the window for an additional inter-meeting rate cut, which the Fed would like to avoid. As we have said before we feel one of the best indicators for the Fed’s move is what the market is currently pricing in. The Fed typically does not disappoint the market. (For a more detailed analysis on Fed cuts and inflation please look at our posts from March 11^th titled “Inflation, Inflation, Inflation” & February 27^th titled “Fed Cuts & Inflation”)

Effective Fed Funds rate pre-March 2008, implied Fed Funds rate post, as of March 14th.

Monday March 17th:
8:30AM: Empire State Manufacturing Survey (Risk: Neutral) The Bloomberg consensus survey indicates the market is currently expecting a reading of -6.3, this would be an improvement from last’s month unexpected drop to -11.7, but still in negative territory. This survey is one of the first indicators monthly indicators released covering the manufacturing sector and thus it is used as a tool to help forecast the overall ISM number. A negative reading of this survey combined with negative readings from the Philly Fed and the Chicago-NAPM can indicate a slowdown in the ISM.

9:15AM: Industrial Production (Risk: Downside) The Bloomberg consensus survey indicates the market is currently expecting a reading of -0.1% on production and a 81.3% capacity utilization rate, compared to 0.1% and 81.5% on production and capacity utilization, respectively. The recent slowdown observed in manufacturing could adversely impact production.

Tuesday March 18th: Fed Day!
8:30AM: Housing Starts (Risk: Downside)- According to Bloomberg.com the market is currently expecting housing starts to total 0.99mn. Permits continue to decline, inventories continue rising, we just don’t see much upside potential for this indicator. (For more information please read our post on the Housing Crisis from March 5^th titled ‘How will it end?’)

8:30AM: Producer Price Index (Risk: Neutral/Slight Upside)- According to Bloomberg.com the market is currently expecting PPI and Core PPI to increase 0.4% and 0.2%, respectively.

2:15PM: Fed Announcement (Risk: Neutral/Slight Upside)- We expect the Fed will cut rates by 75bps and continue to hold a negative bias. We expect the Fed will indicate that they will continue monitoring inflation, and that downside risks to growth still exist and will continue to affect employment. They may also mention in more detail their concerns about the financial sector after the Bear Stearns bailout and surprise rate cut on Sunday.

Wednesday March 19th:
None

Thursday March 20th:
8:30AM: Jobless Claims (Risk: Neutral)- According to the consensus survey Jobless Claims are expected to come in at 360K, still above our 350K threshold.

10:00AM: Leading Indicators (Risk: Neutral)- Bloomberg.com currently states a market consensus of +0.3% M/M change for the leading indicators.

10:00AM: Philly Fed Survey (Risk: Neutral)- Bloomberg.com indicates the market is expecting a reading -20.0 verse -24.0 last month. As with the Empire Survey being released earlier in the week, the Philly Fed will be the second release to address the health of the US manufacturing sector.

Friday March 21st:
Market Closed (Good Friday)

Investment Idea:

Please look at the posting from March 9^th. Also, we have begun looking at long dated Citigroup calls as a possible investment idea. At the same time, we are very concerned about Lehman Brothers and expect to see its shares catch a strong bid.

Chinese Inflation: A Mounting Problem (Update)

The US isn’t alone when it comes to inflationary concerns. Chinese consumer prices continue setting new interim highs, and it is not going unnoticed. February's CPI number came in at 8.7%y/y vs. 7.1%y/y in January. It is important to keep in mind this reading includes the adverse effects of severe winter weather and the Chinese New Year holiday. However, even after these events are factored out the reading remains well above comfortable levels (prices have been trending up since early 2007 from a level of around 1.4%y/y). The data has begun to raise a lot of eyebrows within the Chinese government. Recently, Chinese Premier Wen Jiabao was quoted as saying, “The current price hikes and increasing inflationary pressures are the biggest concern of the people.” So what does it mean?

Inflation continues trending up; as one response we expect policy makers to speed up the appreciation of the RMB

Source: National Bureau of Statistics of China & People's Bank of China

We believe Chinese policy makers will address the rising trend in inflation using the following three policy tools: 1) The Central Bank will increase interest rates, which it hasn’t done since December 07; 2) they will allow the RMB to appreciate at a faster rate; & 3) they will implement new or stronger policies to reduce monetary growth. We also expect the government imposed price controls will remain in place for the foreseeable future. When push comes to shove we feel Chinese policy makers will choose price stability over growth. As we discussed in our last entry on this topic, from February 29^th, food prices have been the primary driver behind Chinese inflation, but recently inflationary signs have started to emerge from the non-food sectors. The longer inflation remains elevated the bigger its effect on inflation expectations. In fact, according to a quarterly survey conducted by the People's Bank of China, inflation expectations have already begun to rise (chart below). This could be bad news for policy makers since a rise in inflation expectations tends to be a self-fulfilling prophecy.

*According to a survey conducted by the People's Bank of China consumers inflation expectations have been increasing significantly with the rise in CPI

Source: National Bureau of Statistics of China & People's Bank of China

*Notes on the Survey of Urban Saving Account Holders (From the People's Bank of China)- The People�s Bank of China conduct a quarterly sampling survey to urban saving account holders nationwide in the form of standardized questionnaire and interview in February, May,August, November each year. The sample size for each survey is 20,000. 4 diffusion indices are derived from the replies of interviewees in questionnaire survey, which reflect the attitudes of people towards current income and price conditions, and the expectations to future income and price trends.

Chinese Inflation: A Mounting Problem

I was asked my views on the Chinese inflation situation today and came up with this short piece:

The Chinese growth story is now sharing the spotlight with the country’s mounting inflation concerns. In January consumer prices rose 7.1%y/y; to a level not seen since 1996, a point when China was in the midst of recovering from levels around 20%y/y. Moreover, based on the current outlook February’s reading is not expected to show any signs of improvement. Starting late January and ending in February China faced a barrage of disastrous winter weather, affecting nearly every aspect of the economy, including crops. This is particularly relevant given that food prices have been the main cause of Chinese inflation, increasing an astonishing 18.2%y/y in January. Important to keep in mind is that January’s reading includes only a small portion of the storm’s total effect, which will be fully reflected in February’s release.

Drilling a bit deeper into China’s inflation problem we look at some of the reasons for the increase in food prices. In part this trend can be attributed to China’s economic success; Chinese economic growth has led to an increase in wealth among its population. With more money to spend Chinese citizens tastes began to shift, in the food sector this meant instead of having vegetables for dinner they preferred meat, especially pork. Since demand for these ‘new’ products are rising faster than they can be supplied, prices are going up. Despite the simplicity of this explanation it could have a significant effect on the Chinese economy. Take this scenario into account; if you expect dinner is going to cost more next month than it did today you are going to ask for better wages to make up the difference. With this in mind inflation expectations have a direct correlation with future inflation based on this principle. Currently, we believe this scenario may already be occurring. Price increases are now showing up in sectors other than food, including services, producer prices, and other non-food products. The increase in service prices could very well imply we are already seeing an increase in the cost of labor due to rising inflation expectations. This scenario will have to be watched closely by Chinese policy makers.

Curtailing the inflation problem will be a tough challenge for Chinese leaders, especially given an increase to inflation expectations. In a more traditional scenario, the solution would simply be a combination of tight monetary policy and conservative fiscal policies. However, a number of problems including reconstruction plans from the winter storms, ‘quasi’ pegged exchange rate, and liquidity factors add up to a unique challenge. Reducing government spending at a time when a large portion of the country’s infrastructure needs to be repaired is not feasible. Additionally, further appreciation of the RMB could reduce exporters’ price advantages to overseas competitors and may reduce Chinese market share lowering economic growth. Finally, increasing rates could make it harder for businesses to borrow within China during a time of industry consolidation; potentially adversely affecting growth. A likely outcome will come by finding a balance between tighter monetary policy and further appreciation in the RMB.

Fed Cuts & Inflation

*Sorry for the delay in posting we were experiencing serious computer issues

One of the questions on everybodys’ minds is how high would inflation need to go before the Fed would reconsider any further rate cuts. During the recent months’ we have seen increasing down side risks to the US growth forecast, while at the same time growing inflation expectations. This is a dangerous mix in terms of continuing to use Fed policy as a stimulus to the economy. Historically, looking back at the data (since 1995), we can see that the Fed has never lowered rates when the Core CPI has gone above 2.9%, this means we could have at some room left, before the Fed rates cuts could potentially come off the table. To further test this we applied an ordered probit model with a grouping of economic indicators (ISM, core PCE – 2.0% inflation target, & a 1 month lag in the change in initial claims - 350) to see how the current situation compares to those in the past and to see which way the Fed is likely to move and in what magnitude based on inflation rates. What we discovered after running the model for both Core CPI and Core PCE (which we see as the Fed’s indicator of choice) was in-line with our original estimation that for the Fed to reconsider the cuts we would need to see the Core rates move to between 2.7% & 3.0%. Currently, the Core PCE and Core CPI are at 2.2% and 2.5%, respectively, with expectations rising.

To quantify the rate change we created five categories ranging from –2 to 2, with 0 implying no change. We created these categories after individually analyzing all FOMC rate changes from 1995 until 2007. To quantify the change we categorized the magnitude of the Fed rate hikes or cuts at each individual meeting into three groups: 0, 0.25%, and =>0.50%. So for example, a rate hike of 0.50% points would lead to a score of 2, while a rate cut of 0.25% would equal a score of -2.

With the left-hand side variable defined this way we ran them using an ordered Probit model against the ISM, inflation gap, and initial claims. We found that all of the variables were statistically significant.

The results show that the implied Fed rate change currently stands at -0.03 on our scale of -2 to 2, and has decreased in intensity over the last two months from its interim low of 0.09 in June (Chart 1). This movement corresponds to the decreasing growth and wavering employment levels. The current reading shows that there is a downward Fed bias, which implies the Fed is more likely to lower rates rather than raise them…

Conclusion:

So long as the Fed considers downside risk to growth exists we can expect that rate cuts will remain on the table as long as Core PCE remains below the 2.7% to 3.0% range, or growth conditions do not deteriorate more significantly.