"The Dilemma Facing the Fed" Market WrapUp by Chris Puplava

The Dilemma Facing the Fed:
Choosing Between the Lesser of Two Evils
BY CHRIS PUPLAVA

Hopefully by tomorrow we will know what concerns the Fed the most and which way they are going to take us. The Fed must choose between saving the economy by going on pause at the risk of continued inflation and a weakening dollar, or they continue their fight on inflation and support the dollar at the risk of sending us into a recession. Thus, a choice must be made between the lesser of two evils. I will illustrate the dilemma the Fed is in. I’ve included economic data on both the inflation picture and economy below, starting with the inflation front.

The inflation picture has remained a concern for the Fed for good reason. The headline Consumer Price Index (CPI) is currently at a 4% annual growth rate, with the core CPI at a 2.5% year-over-year (YOY) growth rate, above the 2% Fed comfort level.

The most recent CPI data for May showed the CPI index rose 0.4% in May following the 0.6% rise in April. The major reason for the large increase in headline inflation was another big jump in energy prices.

Producer prices are also on the rise with the Producer Price Index (PPI) experiencing a 4% YOY growth rate seen in May with core PPI rising just under 2% YOY. The main cause for the rise in producer prices is in energy inputs. Price appreciation among intermediate (1.0%) and crude (2.5%) energy goods remained at elevated levels. In intermediate energy products, jet fuel and home heating fuel saw significant price gains. Crude energy prices for natural gas, crude oil, and coal all rose more than 2.0% in May.

The price increase seen in May was not solely in energy related goods but was broad-based across intermediate producer goods. Construction input prices for the industry rose by 1.2% in May due to rising prices for steel, softwood lumber, and wire. Both durable and nondurable input prices rose significantly for manufactures, up 4.4% and 1.4% respectively. Prices are rising for a wide range of inputs used by construction and manufacturing firms. What is troubling are the price increases seen among core intermediate products that are typically seen as a leading indicator for consumer price inflation. Prices for core intermediate products have risen almost twice as quickly as have prices for core finished products over the past year.

Import prices have also risen substantially in the past year and show no sign of slowing. The Import Price Index rose to an all-time high, currently at 117. As 2000 represents 100 for the index, import prices have risen 17% with a sharp increase seen in the past 2 years.

Currently, import prices are rising at roughly an 8% YOY level. Moreover, the combination of May’s and April’s import price increase is the largest two-month increase seen since October of 1990! The increase in May was led by a 5.2% rise in petroleum prices, less than half the 11.5% jump seen in April. Petroleum prices have risen 45.7% for the year ended in May. The consistently high prices of petroleum imports make it likely that there are still some risk of price pass-through to other goods and services.

The rise in import prices was broad-based as non-petroleum imports also contributed to the rising import prices, increasing 0.6% in May. Non-petroleum prices were fueled by a price increase of 2.5% in May in industrial supplies and materials primarily due to the rising prices of metal, building materials, and chemicals. Prices for non-industrial supplies and materials rose 9% for the year ended in May.

As seen by the four figures and commentary above, inflation is clearly on the rise and a significant concern for consumers and the economy. Not only are we seeing strong inflation figures, but also clear and evident signs of a slowing economy and in particular, a slowing housing market.

The Mortgage Bankers Association of America (MBA) mortgage purchase applications index has continued its decline since last summer as well as their refinance index as seen below.

The mortgage demand downward trend has led the index to fall to its lowest level in four years with both purchase and refinance applications dropped to their lowest levels of the year. This is due to the rise in mortgage rates, which have risen significantly for a second consecutive week. The contract rate on the 30-year fixed-rate mortgage (FRM) increased 13 basis points to 6.86%, while the contract rate on the one-year adjustable-rate mortgage (ARM) rose 14 basis points to 6.36%. The FRM has risen 25 basis points over the past two weeks to its highest level in more than four years with the ARM currently at its highest level in more than five years.

Sales of existing homes have continued to decline, with May’s sales declining by 1.2% from the previous month, according to the National Association of Realtors (NAR). Annualized unit sales are 6.67 million units, down by 6.6% over last year's levels. Furthermore, inventories hit another record and the months of supply having pushed past six months.

The weakness seen in the housing market is also supported by the National Association of Home Builders (NAHB) Housing Market Index. The downward trend seen in homebuilder optimism has continued for eight months since its initial decline in June, falling to its lowest level since April 1995. The factors contributing to the downward trend in homebuilder optimism is the result of higher interest rates, affordability concerns, and subsiding demand from investors and speculators. This had led to residential construction becoming a negative contributor to economic growth instead of the fuel since the last recession with record low interest rats as the catalyst.

Not only is the housing market slowing, but also the employment situation. Total non farm payroll YOY growth reached their lowest levels in March of 2002 and peaked in 2004. Since 2004 non farm payroll increases have been on a steady decline with the potential of rolling.

May’s Net payroll additions were much smaller than expected with only 75,000 jobs created, less than half the expected number. Additionally, private industry gains for the prior two months were revised downward by a total of 41,000. The weakness was broad-based across industries with a large decline (-27,000) in retail trade (clothing stores, specialty retailers, department stores), virtually no growth in construction (expected), declines in information technology (-13,000) and manufacturing (-14,000), and weak gains in just about every other industry.

The higher cost of fuel and other raw materials, such as steel mentioned above, in import prices is behind the downward shift in manufacturing payrolls. Continued restructuring in the motor vehicle industry was responsible for the May decline to a large degree (-9,700), and other manufacturers cut back as well. Construction payrolls, which usually plump up in the spring, registered virtually no gain on a seasonally adjusted basis due to the slowdown in housing. What is troubling is the payroll addition in mining and natural resources weakened in May in part due to a shortage of qualified workers in these industries. The average workweek declined to 33.8 hours, as did the manufacturing workweek, to 41.1. A declining workweek is a signal for a potential slowdown in employment growth, which is what we are currently seeing, supporting the view of a current slowdown in the economy. In summary, service producing payrolls increased by only 77,000 in May, half the pace found during the first quarter of this year.

Further putting a drag on the economy is the trade deficit. In April, imports of crude oil amounted to $16.7 compared to $16.3 billion in the previous month. The price of crude oil was roughly $4.60 per barrel higher in April than in March, though the quantity of imports decreased from 312 million barrels in March to 293 million barrels in April. The total energy-related petroleum products imported amounted to $23.4 billion in March compared to $21.5 billion in the previous month. This puts our foreign energy bill at roughly one third of the trade deficit showing the degree of our foreign oil dependency where we are sending $23.4 billion U.S. dollars overseas instead of towards American Energy companies and our economy.

Energy imports have remained a persistent factor in our trade deficit. The Jan-April cumulative value of energy-related petroleum imports, not seasonally adjusted, is $88.2 billion this year compared to $67.2 billion in 2005.

Another area that is adding to the slowdown in the U.S. economy is vehicle sales. May vehicle sales showed the troubling state of U.S. brand manufacturers. The decline in vehicle sales in May was felt the most by U.S. brands, which fell by more than 400,000 on a seasonally adjusted annualized basis (SAAR). The biggest fallout was seen in SUVs, where consumers turned away en masse from the gas guzzling for which U.S. brands depend on most of their profits.

On a non SAAR basis, GM's sales fell a large 16% from a year ago, Chrysler's sales fell by 11% and Ford's sales fell by 6%. What is important to note is that while GM and Ford have been experiencing year-over-year losses for a while and Chrysler's losses are more recent.

In stark contrast, Toyota and Honda continue to gain strongly over the Big Three, benefiting from rising car sales. Toyota's car sales are 25% higher than a year ago and much of this gain is from imported vehicles. Honda's car sales are 21% higher over the year.

U.S. market share has been tumbling rapidly as a result. While fuel prices hover around $3 a gallon with the potential to rise even further during the driving season, it will be very difficult to keep consumers from turning away from U.S. brand SUVs furthering the decline in market share for U.S. auto companies.

What is demonstrated above is a troubling inflation picture as well as a weakening economy. Tomorrow will shed some light on the Fed’s choice of fighting inflation and supporting the dollar at the expense of an already weakening economy, or a calling a pause to interest rates to support the economy at the expense of rising inflation and a weakening dollar. Either way, the Fed has to choose which is the lesser of the two evils.

In economic news, the MBA’s Purchase Index was released today and as mentioned above, and fell 6.2% in the June 23 week over the previous week. Crude oil inventories fell 3.4 million barrels in the June 23 week, a far greater plunge than was expected. Gasoline stocks fell one million barrels in contrast to an estimated small gain. The drawdown in oil and gasoline inventories may feed new gains in oil prices, and energy shares rose on the news, with the Philadelphia Oil Service Index (OSX) rising 1.19%, and the AMEX Oil (XOI) and Natural Gas (XNG) indices also rising 1.87% and 1.42% respectively.

After initially declining in morning trading the markets rallied in the afternoon to put in a gain for the day. Advancing issues represented 58% and 51% for the NYSE and NASDAQ respectively, with up volume representing 64% and 59% of total volume on the NYSE and NASDAQ.

All of the broad market indices were up, with the DJIA posting a 48.82 point gain to close at 10,973.56, the S&P 500 up 6.80 points to close at 1246.00, and the NASDAQ up 11.59 points to close at 2111.84. The 10-year Treasury note yield rose 3.5 basis points, with the yield closing at 5.245% with the dollar index also posting a moderate gain, rising 0.19 points to close at 86.66.

Overseas, Japan's Nikkei stock average fell 1.88%. Britain's FTSE 100 rose 0.47%, Germany's DAX index fell 0.04%, France's CAC-40 rose 0.06%, and Mexico’s Bolsa was up 0.45%.

By sector, energy shares rose the sharpest with the S&P 500 Energy sector rising 1.97%. The S&P 500 Utilities and Financial sector also put in modest gains, up 0.45 and 0.48% respectively. All of the nine S&P 500 sectors were up on the day with the weakest showing coming from the consumer discretionary sector, up 0.14%.

Spot gold prices rose slightly, up $0.50 an ounce to close at $579.55 an ounce, West Texas Intermediate Crude (WTIC) oil rose $0.27 a barrel to close at $72.19 a barrel, and Henry Hub spot natural gas prices rose $0.08 per mBTU to close at $5.97 per mBTU.

CONTACT INFORMATION
Christopher M. Puplava
PFS Group
PO Box 503147
San Diego, CA 92150-3147
(888) 486-3939 Toll Free
(858) 487-3939 Tel
(858) 487-3969 Fax
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