U.S. Weekly Financial Notes: The Heat Is On

The statement at the Federal Reserve's April 24-25 Federal Open Market Committee's (FOMC) policy meeting wasn't surprising, but in his press conference this week, Mr. Bernanke stated that the Fed's 2% inflation target is not a ceiling, suggesting that the central bank has more room for keeping an easy-money policy. Other economic releases this week include:

• In the advance estimate, U.S. real GDP rose at an annualized 2.2% rate in the first quarter.
• The U.S. Employment Cost Index (ECI) rose 0.4% in the first quarter.
• The February U.S. S&P Case-Shiller 20-city home price index fell 3.5% over last year.
• The February Federal Housing Finance Agency (FHFA) home price index rose 0.3% over January and 0.4% year-over-year, the first annual gain since July 2007.
• U.S. March new home sales fell 7.1% over February to an annualized pace of 328,000 units. The months' supply of homes fell to 5.3 months from 5.2 months in February. The median price fell 1% over February to $234,500 in March.
• U.S. March pending existing home sales rose 4.1% over February.
• March U.S. durable orders fell 4.2% over February. Nondefense core capital goods orders, excluding aircraft, a leading indicator for business investment, fell 0.8% over February.
• U.S. consumer confidence fell slightly to 69.2 points in April from 69.5 in March.
• Thomson Reuters/ University of Michigan's final April consumer sentiment index rose to 76.4 points from 76.2 in March and April's preliminary reading of 75.5 points.
• Initial jobless claims fell by 10,000 to 388,000 in the week ended April 21, still below the 400,000 benchmark, signaling a job market in recovery territory. Continuing claims rose by 3,000 to 3.315 million during the week ended April 14.
• Oil prices rose $1 from last week to $104/barrel on early Friday afternoon.

Closing Shop

U.S real GDP rose at an annualized 2.2% pace in the first quarter, decelerating from a 3.0% rate seen in the fourth quarter. It was much weaker than the 2.5% expected by consensus, though it was in line with our forecast of a 2.1% pace, because of surprising soft nonresidential fixed investment and continued spending cuts by the government. Strength in consumer spending and residential investment helped to offset the weakness. GDP grew 1.7% for 2011, consistent with the slow pace of recovery that we expect.

Though the bleak durable goods report hinted at a bad number, the private-sector fixed investment figure was a disappointment, growing at a 1.4% rate the first quarter, after a solid 6.3% pace during the fourth quarter. We expected that the unwinding of the tax incentive in 2012 would reduce equipment spending, after three years of double-digit gains. But the meager 1.7% rate for the first quarter was much weaker than the 8.3% we had expected. Net exports added $700 million to first-quarter growth, after an $8.0 billion drop previously. The 12.0% decline in nonresidential construction spending was also disappointing, although the 19.1% jump in residential construction, a rate not seen since the second quarter of 2010, which better weather helped lift up, offset the news.

The government continued to cut spending during the first quarter. Government spending fell 3.0% in the first quarter. It is the sixth consecutive quarterly decline, which is the longest stretch of declines since the unwind in 1955 after the Korean War. State and local municipalities continue to shed programs (and jobs) now for the seventh consecutive quarter, in an attempt to balance budgets.

The risk of fiscal tightening and policy uncertainty amid negative real household income could undercut growth later this year.

Inventory accumulation contributed 0.6% to growth during the first quarter, despite its whopping 1.8% contribution to GDP in the fourth quarter. If inventories were flat, GDP would have been 1.6% in the first quarter and just 1.2% in the fourth. The buildup in inventories suggests soft second-quarter growth prospects, as shelves won't need to be restocked, since they are already full.

However, consumers are doing their best to empty the shelves, with spending up by a strong 2.9% in the first quarter. Given the robust March retail sales data reported last week, it wasn't too surprising. Spending on durable goods rose 6.2% in the first quarter, while spending on nondurable goods surged 15.3%. Services were up just 1.7%, with spending on housing and utilities and other energy related spending down, given the warm weather.

March orders for durable manufactured goods plunged by 4.2% over the February rate, which was much worse than the 1.0% decline expected by consensus and erased the 1.9% month-over-month gain seen in February. Durable orders have still posted month-over-month gains in four of the last six months, and are up 9.1% year-to-date. Transportation orders fell 12.5% over February, largely due to a huge 47.6% drop in volatile civilian aircraft orders. Auto orders edged up just 0.1% for the month.

It wasn't just an aircraft issue. Excluding transportation, orders still fell 1.1% month-over-month, although these are up 8.2%, year to date. Moreover, core capital goods orders (excluding defense and aircraft)--a key leading indicator for business investment—dropped by 0.8% month-over-month in March, but remain up 8.3% year-to-date. At least core shipments were up a solid 2.6% and up 8.4% year-to-date. Inventories rose 0.4% over February, which marks their 27th consecutive month of growth. Overall, the softer-than-expected orders data foretold the weak equipment spending reading for first quarter GDP report.

Spring Buying In Winter

Though the housing sector continues to struggle, there were some sweet surprises in the data this week. The S&P Case-Shiller 20-city home price index fell 3.5% over last February-- although it is decelerating from the 3.9% year-over-year decline seen in January and a bit softer than the 3.8% decline we expected. All of the fifteen cities that saw year-over-year declines, also saw single-digit declines--except Atlanta, which was down 17.3%. All fifteen cities saw better annual returns in February than January. The 20-city index was up 0.2% over January, on a seasonally adjusted basis, as the warm winter helped to push spring and summer buying activity into the winter months. It was down 0.8%, on an unadjusted basis. Phoenix finally appears to be turning the corner, with now two straight months of positive year-over-year gains in home prices and five straight months of positive monthly returns. Along with Phoenix, only Miami and San Diego reported positive month-over-month gains of 0.6% and 0.2%. The 20-city index is now down 35% from its July 2006 peak. We expect that tight lending standards, income-constrained consumers, and the shadow inventory of unsold homes, particularly distressed properties, will continue to weigh on prices, pushing them down another 1% from the current level to a new record-low of 36% from the July 2006 peak later this year.

People were also buying during this winter. U.S. new home sales fell 7.1% month-over-month to an annualized pace of 328,000 units in March, although is up 7.5% year-over-year. The level was still stronger than the 318,000 units expected by consensus, since sales for February were upwardly revised to a 7.3% year-over-year gain to 353,000 (previously 313,000), which was the fastest pace since November 2009.

Sales in the South and the Northeast reported monthly gains (up 3.1% and 7.7%, respectively), while the Midwest and the West saw declines (down 20.0% and 27.0%, respectively) after solid gains in the previous month. The amount of time new homes spent unsold on the market rose to 5.3 months from 5.2 months in February, but this figure remained near normal market levels of about 5.5 months, as the number of new homes on sale at the end of March fell to a record-low of 144,000 units. Of course, it doesn't take into account the shadow inventory of unsold homes, which adds several more months to the overall amount of unsold homes that need to be unwound. The median price fell 1% month over month to $234,500 in March, though it is up 6.3% over last March.

Still In The Game

Not surprisingly, the Federal Reserve's April 24-25 Federal Open Market Committee (FOMC) monetary policy announcement kept the federal funds rate at near zero and kept quiet on any hint that there will be more easing down the road. The Fed was also more optimistic in its new growth projections and more hawkish on inflation projections than they were in January, though the statement still said that "significant downside risks" remain. The statement also noted that the growth forecast for 2012 was pushed up 2.0% to a range of 2.4% and 2.9%. Unemployment at the end of 2012 declined to 7.8% to 8% (was 8.2% to 8.5%). They did reduce growth projections, suggesting increased concern over the economic outlook as the fiscal cliff approaches at the end of the year. Although the FOMC anticipates that "inflation will run at or below the rate that it judges most consistent with its dual mandate," the Fed projects a higher inflation range this year of 1.9% to 2% (was 1.4% to 1.8%).

Aware that economic headwinds lay ahead, in his press conference after the meeting, Mr. Bernanke defused market concerns that the stronger inflation projections meant that the Fed would be forced to race the federal funds rate much sooner than what the statement said. He stated that the inflation target of 2% is not "a ceiling," indicating that the Fed has room to move. Although 10 Fed members forecasted that the federal funds rate will be at 1% or greater by late 2014, Mr. Bernanke reiterated that the estimates "are inputs into a committee process" and that 9 out of 10 members were comfortable with keeping interest rates near zero through late 2014. Although the Fed projects a higher inflation range this year of 1.9% to 2% (was 1.4% to 1.8%), the forecast meets the FOMC's anticipation that "inflation will run at or below the rate that it judges most consistent with its dual mandate."

Contributor: Sonika Tyagi

Financial Market Highlights

Below are the financial market highlights for the week ending April 27, 2012.

Treasury yield curve

The 10-year Treasury yield fell to 1.95% on Friday (early afternoon) from 2.00% last week, after Standard & Poor's lowered Spain's sovereign debt rating, renewing concern that Europe's debt crisis is deepening, and consequently boosting demand for safer assets. The rate of three-month Treasury bills increased 1 basis point (bp) to 9 bps this week. The two-to-10-year spread dropped 2 bps to 172 bps over the week and was 100 bps less than a year ago. The 10-year Treasury spread above inflation-protected bonds (TIPS), a measure of inflation expectations, remained stable at 163 bps over the past week and was 23 bps less than the previous year.

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Chart 1

Credit markets

Renewed concerns over Europe and rising speculation about slowing global growth weighed on investor sentiment, increasing risk aversion in all market segments this week. The equity market volatility index (VIX), a measure of the market's uncertainty, fell to 17.51 from 18.91 the previous week. The T-bill-to-eurodollar (TED) spread, a measure of banks' willingness to lend, fell 1 bp to 38 bps this week and was up 17 bps from a year ago. Fixed mortgage rates dipped to 3.88% from 3.90% last week. Mortgage applications rose 3.8% during the week ended April 20, after rising 6.9% the previous week. The refinance index surged 5.6%, after rising 13.5% the prior week. The purchase index rose 2.7%, after slipping 11.2% the previous week.

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Fed policy and interest rate outlook

The Federal Reserve's April 24-25 Federal Open Market Committee's (FOMC) monetary policy statement was almost identical to its March statement, with the same late-2014 commitment for "exceptionally low levels for the federal funds rate." It didn't hint at another round of quantitative easing or more Operation Twist. The Fed still said that the "economy has been expanding moderately" and that it "expects economic growth to remain moderate over coming quarters and then to pick up gradually." The Fed was careful to add, however, that growth remains threatened by the "downside risks" associated with strains on global financial markets. It said again that the higher oil and gasoline prices "earlier this year" are expected to affect inflation only temporarily. Richmond Fed President Jeffrey Lacker dissented for the third meeting this year. The statement came in about as expected, indicating that the Fed is waiting to see which way the recovery turns before it commits to more policy action. The Fed released its new economic projections, which are more optimistic and hawkish. The growth forecast for 2012 was pushed up to a range of 2.4% and 2.9%, higher than the 2.2% to 2.7% projections in January. Unemployment at the end of 2012 is now expected to be about 7.8% to 8%. The Fed projects a higher inflation range this year of 1.9% to 2%, up from the previous range of 1.4% to 1.8%. Previously, policymakers were split on what type of accommodative monetary tools the central bank should use to try to kick start the economy. While there were a number of opinions on the inflation outlook, most judged that inflation risks were roughly balanced with little risk of deflation. The Fed decided to extend the maturities on its balance sheet (this is called Operation Twist), although two officials wanted to do more and others wanted to hold open the option for QE3. However, the members generally anticipated a pickup in the pace of the recovery even though they saw "significant" risks to growth, with the recovery more vulnerable to shocks. The Federal Reserve's 12-district April 11th Beige Book noted that economic activity grew at a "modest to moderate" pace over the last month, using the same descriptors for the activity rate that appeared in the previous two reports. It noted manufacturers' and retailers' concerns over rising oil prices. At the same time, unusually warm weather helped retail sales. Overall, the report noted that manufacturing was expanding, new-car sales were strong, professional business services were growing, and freight volume was increasing—all of this alongside favorable agricultural conditions, accelerated mining and oil extraction, and minor improvements in loan demand. Real estate activity was lackluster. Hiring held steady or rose modestly, while employers noted the difficulty of finding highly-skilled workers. Wage growth was "constrained," and price inflation was modest.

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Global interest rates

Government long-term bond yields were largely up this week. Key central banks remain cautious in their outlook. Recent trends include:

• The European Central Bank (ECB) maintained its benchmark refinancing rate at a low of 1% on April 4 because of rising inflation worries, while some eurozone nations battle economic contractions amid the ongoing eurozone debt crisis.
• The Bank of England held its bank rate at 0.5% at its April 4 meeting due to concerns over higher energy prices and the continuing debt crisis in the eurozone.
• The Bank of Japan kept its monetary policy on hold on April 27. It boosted its bond-buying scheme by another 10 trillion yen and kept expectations of more stimulus alive, as it pledged to "pursue powerful monetary easing" to reach its 1% inflation target.
• The People's Bank of China lowered the required reserve ratio by 50 bps, effective Feb. 24, 2012, because Europe's debt crisis and a cooling property market threaten China's economic growth. The ratio for large banks was thus reduced to 20.5%.
• The Bank of Canada held its target overnight rate at 1% on March 8 because of signs of improvement in the global economic recovery and underlying momentum in the Canadian economy (that remained around trend).
• The Norges Bank reduced the deposit rate by 50 bps to 1.75% during its meeting on Dec. 14 in order to guard the economy against deteriorating global growth.
• Sweden's Riksbank kept its seven-day repo rate unchanged at 1.50% on April 18 amid signs of an improving economic recovery, and asserted the monetary policy needs to remain expansionary to support the country's recovery.
• The Swiss National Bank cut its interest rate target band to 0.00%-0.25% from 0.00%-0.75% to stem the rise of the Swiss franc.
• Poland's central bank left its seven-day reference rate at 4.50% on April 4, and for the 10th month, but warned that rates might rise if inflation remains elevated and the domestic economy avoids a steeper downturn.
• The Reserve Bank of Australia (RBA) kept its official cash rate target at 4.25% on April 4, as global and domestic economies continue to grow below trend-growth, and inflation expectations remain contained.
• The Reserve Bank of New Zealand left its key rate unchanged at 2.5% on April 26, citing signs of recovery, especially in the housing market, but warned of benign inflation and a high local dollar.
• South Korea's central bank left its key interest rate unchanged at 3.25% on April 12 for a 10th straight month amid lingering concerns about inflation and the slow global economic recovery.
• The Bank of Thailand held its benchmark overnight rate at 3.00% on March 21, pausing after two consecutive rate cuts because of rising inflationary pressures.

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Foreign exchange rates

The dollar dropped this week against other major currencies, following data that showed that U.S. GDP growth cooled during the first quarter, raising the prospect of further stimulus from the Federal Reserve. The euro rose to $1.325/€ on Friday (early afternoon), from the previous week's $1.308/€ after a smooth Italian bond auction eased concerns over peripheral euro zone debt markets and offset jitters sparked by a downgrade of Spain's sovereign debt. The yen rose to ¥80.44/$ on Friday (early afternoon) from ¥80.96/$ the previous week, after the Bank of Japan enacted monetary stimulus for the second time in three months. The U.S. trade deficit narrowed to $46.0 billion in February from a $52.5 deficit the previous month. The narrower-than-expected deficit reading was largely explained by a drop in imports, which fell to $227.2 billion in February from $233.4 billion the month before. Exports increased by a modest $300 million to $181.2 billion in February.

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Commodity price indices

Commodity prices gained this week after U.S. GDP growth slowed more than expected in the first quarter and as a result of renewed concerns about the eurozone after a downgrade of Spain's debt. Oil prices rose to $104.29/barrel on Friday (early afternoon), from $103.07/barrel last week, as a result of concerns about global demand, following some weak economic data from the U.S. and China. Brent crude oil price decreased to $119.47/barrel from $121.21/barrel and remains high relative to West Texas Intermediate (WTI). Natural gas prices fell this week to $3.195/mbtu from $3.321/mbtu last week. Gold prices rose to $1,665/ounce on Friday (early afternoon) from $1,658/ounce last week as softer-than-expected U.S. GDP growth data weighed on the dollar. Livestock prices dipped 2.1% this week and decreased 8.8% over the past year.

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U.S. equity market

Equity markets swung between gains and losses as investors weighed improving earnings and consumer confidence data against lower-than-forecast U.S. quarter one GDP growth and a downgrade of Spain's credit rating. The S&P 500, Dow, and Nasdaq were up and trading at 1,403, 13,241, and 3,066, respectively, on Friday early afternoon. Stocks were in a bear market from October 2007 until March 2009. Despite recent losses, they have now recovered much of those losses. The S&P 500 is now up 11.52% from the end-of-2012 level of 1,258 and is up 107.54% from its March 9, 2009 low of 676.

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U.S. equity market by sector

Equity sectors gained this past week, through Thursday, except information technology and consumer discretionary stocks, which were down 0.9% and 0.2%, respectively. Telecom and utilities stocks led the gainers, up 2.5% and 1.4%, respectively, following strong corporate results. Information technology and consumer discretionary stocks saw the largest 12-month gains, up 12.6% and 11%, respectively. Energy stocks, burdened by supply concerns and weak global demand, posted the largest 12-month decline (down 11%).

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Global Standard & Poor's stock indices

World equity markets remained mixed this week through Thursday, as weak Chinese economic data and renewed concerns over the Eurozone debt crisis overshadowed Japan's move to expand its economic stimulus and corporate earnings that beat estimates. The Australian and U.S markets were the only gainers this week, up 1% and 0.2%, respectively. In contrast, Canadian markets led the decliners, down 0.6%, closely followed by Asia-Pacific and Latin-American markets, both down 0.5%. All major global equity markets, except the U.S. markets, have now turned negative for the 12-month period, led by Latin-America (down 15%).

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Global equity market performance by sector

International sectors gained this week, through Thursday. Telecom and energy stocks led the gainers, up 2.9% and 2.1%, respectively. During the past year, information technology and consumer staples stocks posted the largest gains (up 8.3% and 6%, respectively). In contrast, material stocks dropped the most during the past year (down 20.4%), followed by financial stocks (down 16.8%).

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Data tables and text provided by Kaustubh Pandey at Standard & Poor's/CRISIL.