Policy Dilemma Eases

US data in recent days helped ease concern that the economy is not strong enough to withstand the kind of tightening the Federal Reserve may need to enact in order to return inflation and inflation expectations back within officials comfort zone. And make no mistake about it, the pendulum of market sentiment has swung hard, abandoning the one and done view, which has really been a persistent pattern of thought throughout the two-year old tightening cycle.

The Fed’s hawkish campaign begun in earnest with the speech by Federal Reserve Chairman Bernanke on Monday June 5, coupled with the third consecutive 0.3% rise in the core CPI measure, removed any doubt in the market’s mind that the Federal Reserve will raise rates on June 29th. Indeed, the pricing of the July Fed funds futures contract implies a small chance (less than 5%) of a 50 bp move. The market also recognizes that it may take more than another rate hike to lower inflation expectations.

The next FOMC meeting is on August 8. Assuming that the Fed funds target of 5.25% is achieved on average during the first eight days in August and that the Fed were to raise rates 25 bp to 5.5%, fair value for the August Fed funds futures contract would be 94.57 or 5.43% implied yield. If the Fed were to raise rates in June but pause in August, fair value would be 94.75 or 5.25% implied yield. As this note is penned, the August Fed funds futures contract is trading at 94.63 or 5.37% yield. That is to say that 12 of 18 basis points (the difference between 94.75 and 94.57) is being discounted, which is equivalent to a two-thirds chance of an August hike on top of a June hike.

One of the most disappointing real sector reports was the 0.1% decline in May industrial output. However, it is important not to exaggerate the significance of that decline. It follows a strong 0.8% increase in the April. That means that the average monthly increase in Q2 is running at a 0.35% increase, which compares to a 0.26% average monthly increase in Q1 06 and a 1.0% average monthly increase in Q4 05.

Methodologically, knowing industrial production figures does not help in forecasting GDP. Recall that in Q4 05 the US economy expanded only 1.7% at an annual pace even though industrial output expanded at something like four times the pace as in Q1 06, when the GDP expanded at a heady 5.3% pace. This makes intuitive sense not because the US has de-industrialized, which is not true, but because of the growth of the US sector. Manufacturing, the key to industrial production, accounts for less than one fifth of GDP. The truth is that the US produces more goods than ever before, but the real rub is that it is doing so with a smaller workforce. This is the one way in which productivity gains is reflected in the economy.

In addition, some of the indicators that offer insight into business investment is robust, helping to pick up the slack created by a slowing of household demand The output of business equipment goods rose at a 14% annualized pace in the April-May period after 11.1% in Q1 06. The June Philadelphia Fed survey bears this out, with strong increase in new orders (17.7 from 2.7) and shipments rose to 17.7 as well from 11.7. The Empire Manufacturing survey was much stronger than expected rising from an upwardly revised 12.9 reading in May. To put it in perspective, barring the March reading 0f 29.03, it is the highest since July 2004, the month after the Fed’s tightening cycle began.

Capacity utilization rates slipped. May’s 81.7% rate compares with 81.9% in April, but the pullback is likely significant and if one were concerned about the resource utilization rates, as the Fed has indicated it was, the report offered little comfort. When the US was not in a recession, capacity utilization rates have run near 80.5% on average and in manufacturing 79.5%. On both counts, current usage is above these averages.

A similar signal may be coming from the other element of the resource utilization issue, the labor market. The May jobs report was disappointing, but there is some reason to expect a recovery in the June report. The 34k decline in weekly Initial jobless in the week to June 2 was dismissed because of distortions caused by the Memorial Day holiday. However, weekly initial jobless claims fell again in the week to June 9. At 295k, it stands at its lowest level since mid-February. The less noisy 4-week moving average stands at 315.7, down from a 333 peak in late May. The employment component of the Philly Fed survey also suggests improvement in the labor market conditions (6.8 vs 1.1).

The evidence then in recent days that the US economy is not falling off the cliff; that talk about stagnation is well off the mark, is contributing to the stabilization of the global capital markets. Bernanke did his part as well. The stream of hawkish comments from every Fed official that has spoken is recent sessions had taken a toll, but on June 15, two weeks shy of the second anniversary of the tightening cycle, Bernanke sounded slightly less hawkish—not dovish, just less hawkish. And this too helped calm the global capital markets.

Bernanke said two things that captured the market’s attention. First he was optimistic that over the long term, the higher energy costs were manageable, even if it slowed growth and boosted price pressures in the short-term. This speaks to a Chairman looking beyond the noise and toward the underlying signal—the strength and flexibility of the US economy. Second, and perhaps more importantly, Bernanke acknowledged the some market based measures of inflation expectations have fallen back in the past month. It is true. Such measures include the TIPS spread over (break-even) over conventional Treasuries has narrowed slightly. The yield curve as measured by the difference between 2- and 10-year US Treasuries has gone inverted after stepping earlier in the spring.

In addition, the University of Michigan’s consumer confidence survey queries about inflation expectations and these fell in the preliminary June reading. The one-year expectation fell back to 3.4% from 4.0% in late-May. The 5-year measure eased to 3.0% from 3.2%. Although the late May gains might be attributable to the rise in gasoline prices, which has stalled, it is reasonable to suspect that the hawkish comments by Federal Reserve officials helped as well.

Bernanke’s acknowledgement also helped ease fears that the FOMC would lift rates much beyond neutrality, which San Francisco Fed President Yellen quantified as between 3.5% and 5.5%. Not only did US shares respond favorably to Bernanke’s comments, but the Fed funds futures stopped falling (implying higher rates) and the US yield curve became slightly less inverted.

In a highly unusual pattern, the US dollar appeared to actually benefit while global equities and commodities were selling off hard. It is unusual because turmoil in the global capital markets is often associated with disruptions to the smooth financing of the US current account deficit. This seemed to be more a function of unwinding positions than an outright bullish stance toward the US dollar. There is not much in the way of important data due out in the days ahead that will have significant impact on the foreign exchange market. Although the euro and sterling recorded their highs for the week on Friday 16 June, the price action was not confirmed by the Swiss franc. If the euro fails to rise above $1.2670-80, the risk is for another set back to retest the $1.2500-20 band of support. A break of that support could signal another cent decline.

Expectations on the timing of the first rate hike from the Bank of Japan are in the process of being reassessed. Many had thought a hike in June was likely and then expectations had shifted to July. A Reuters survey warns that expectations are being pushed back into August. This keeps the yen on the defensive. The market still wants to see the gap created by the dollar’s sharply lower opening after the G7 meeting in late April to be tested. The gap is found between JPY115.97 and JPY116.56. At the same time, the yen is poised to fall to new record lows against the euro.