Wednesday, April 18, 2007

A Fed Rate Cut or Increase?

Much has been speculated regarding the likelihood of a rate hike or a rate cut. Most of the investment community appears to be betting on a rate cut, at least according to the reaction of the markets to recent economic news. Below I list the good economic news and the challenging economic news. In my estimation the recent economic news will limit the Fed to making no rate change at its next meeting on May 9. In my judgment and according to our 3 monthly economic surveys, excessive inflation is clearly the greater economic danger.

Opportunities (The Bullish News)
* The data showed U.S. non-farm payrolls rose by 180,000 last month, beating a median market forecast of 120,000. The unemployment rate declined to 4.4%. The Fed is not comfortable with this low unemployment rate in light of the inflation data.
* Hourly wages for IT pros have hit the highest levels since 2001. The average hourly wage for IT workers was $31.30 in the first quarter of 2007, the highest since January 2001.
* Average hourly earnings of production and nonsupervisory workers on private nonfarm payrolls rose by 6 cents, or 0.3%, in March to $17.22.
* The US trade deficit saw a modest decline in February to $58.4 billion from $58.9 billion in January as the balance with China improved. The deficit with China fell 13.3% from a month earlier to $18.4bn. Despite the drop, this still represents about a third of the overall deficit. Exports to China rose 6.1% to $4.63 billion while imports from the Asian powerhouse declined 10% to $23 billion.

Threats/The Bad News (Dangers)

* Wholesale prices rose by 1% in March with the core, which excludes food and energy, the same as February. The 1% increase in the Producer Price Index (PPI) followed a 1.3% surge in February. (I know some economists view this report as positive---I don’t see it that way).
* The initial jobless claims report for the week ending April 7 showed an increase in the level of unemployment with initial claims rising 19,000 from the previous week's revised figure of 323,000. The 4-week moving average was 323,250, an increase of 7,000 from the previous week's revised average of 316,250.
* Consumer sentiment hit an eight-month low this month amid rising gasoline prices and inflation fears and a troubled housing market, according to the Reuters/University of Michigan Surveys of Consumers report released last week.
* The U.S. Import Price Index rose 1.7% in March—too high for comfort.
* The consumer foods index rose less in March than it had a month earlier-1.4% and 1.9%, respectively. This should be more of an inflation concern than it has been.
* The No. 2 subprime mortgage lender New Century filed for bankruptcy protection on April 2, 2007, while the No. 1 subprime lender, HSBC, has taken $10.6 billion charge for bad loans, primarily in its US mortgage unit.
* Long-term interest rates are creeping up. Keep an eye on the 10-year U.S. Treasury bond yield.

What to watch for
.Advance Gross Domestic Product growth for quarter 1, 2007 will be released on April 27 ( Annualized growth between 1.5% and 3.0% will be neutral. Above 3.0% will raise inflation concerns.
Employment situation for April (May 4th Another very strong job number (e.g. greater than less than 180,000) and a downward move in the unemployment rate will have a significant impact of inflation concerns by the Fed and investors.
Regional and national ISM reports (May 1st and ). Keep an eye on the overall index. Another increase in the inflation gauge will raise inflation concerns among investors.
The FOMC meetings on May 9 will be closely watched. While there will be no rate change, the statements in the release will be very important. I expect the statement to show inflation concern.

The Outlook

· I expect long-term interest rates are forecast to drift slightly higher, with the 10-year Treasury note yield reaching 5.00% at year-end 2007. This will mean mortgage rates will rise by 25 basis points ( ¼%).
· Weaker business fixed investment and the ongoing recession in the housing sector are, therefore, likely to become a more perceivable drag on the US labor market over the next few months. If hiring in the construction sector remains clearly below the normal level, this can already lower the seasonally adjusted non-farm payroll figure in April by up to 100k.
· I expect the Federal Reserve to reinforce their concern of rising inflationary pressures and to maintain their bias toward raising rates at their May 9 meetings.
· The European Central Bank’s (ECB) decision to keep rates unchanged at 3.75% rather than pursuing the more hawkish head of the ECB, Mr. Trichet, who hinted that a repo rate of 4.00% was possible by June. This will put downward pressure on the U.S. dollar and upward pressures on U.S. interest rates.
· With the U.S. average retail price for regular gasoline now above $2.80 per gallon, the National Association of Business Economics (NABE) determined that average gasoline prices above $3 per gallon will cause Americans to change their driving habits.
· Sub-prime mortgage lending was identified by the NABE forecasters as posing the greatest risk to financial markets.
· The NABE group now looks for the Federal Reserve to remain on hold throughout 2007, with the federal funds rate remaining at 5.25%.
· Realtors expect the first nationwide drop in home prices this year since the Great Depression. The 2007 median price for an existing home likely will decline 0.7% to $220,300, the first drop since the real estate trade group began keeping records in 1968 and probably the first decline since the Great Depression, said Lawrence Yun, an economist with the National Association of Realtors.

Watch out for a market correction in recognition of greater inflationary pressures.

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