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INTEREST RATES MOVE LOWER

After a couple days of good economic news, a negative report from the Midwest this morning set a negative overall tone for the markets today. Monday and Tuesday we saw signs of strength from the consumer with higher spending in May and a surge in consumer confidence from a report on Tuesday. After a reading of 68 in May, economists were forecasting the Chicago Purchasing Managers’ Index to come in at 65, but instead dropped all the way to 56.4. Reuters reports, “The unexpectedly severe drop in the Chicago PMI to an eight-month low echoed two successive monthly declines in durable goods orders in April and May.” This report was surely the icing on the cake the Fed will raise interest rates, but will do it very slowly. This report also demonstrates the competing forces of inflation and deflation at odds with each other in the markets today.

We saw increasing pressures for inflation on Monday when the Commerce Department reported the Personal Consumption Expenditures Index having its largest increase in 14 years. In the Chicago PMI data released today, the inflationary expectations were confirmed as the Chicago group’s Index of Prices Paid rose to 84.5 this month from 80 in May. This is a huge month over month increase of 5.6%, which means the Fed has to raise rates by a quarter-point to remain credible on fighting inflation. They can’t raise more than the quarter-point because the two biggest weaknesses in the PMI report came from the drop-off in production and new orders. The big drop in the PMI has been attributed to slowing vehicle sales, and the Midwest region builds roughly 40% of U.S. motor vehicles.

We are coming off an extended period of massive monetary and fiscal stimulus with easy and inexpensive credit supporting pumped-up consumer and government spending. Low interest rates have allowed automobile manufacturers to sell new cars with 0% financing, and now Chicago is seeing a big slowdown BEFORE we see rates move significantly higher. As financing costs move up, it will become increasingly difficult for auto dealers to sell their product. Add to that the glut of good quality used cars on the market, and I don’t think we will be seeing good year over year comparisons for auto sales moving forward. The economy is slowing down on its own, and will be helped along with the higher cost of credit. We do so many thing in this country on credit, how could higher rates possibly do this market any good? Even for fixed-income investors that need higher rates to generate interest income, the increases won’t be enough in the near-term to keep up with inflation…therefore the returns will be bigger, but in reality smaller when adjusted for inflation.

A big portion of the monetary stimulus has come from consumers extracting equity from their homes. In fact, with all the refinancing activity in the last couple years, how many households do you suppose used some of their cash-out home equity to buy some of those new cars racing around our freeways? The Mortgage Bankers Association said again today that overall mortgage applications dropped by 4.4%, with the purchase index falling 4.2% and the refinancing index falling by 4.7%. The 30-year fixed rate remained the same as last week at 6.21%, but the economy is clearly losing stimulus from the housing sector.

Bonds, Stocks, & Dollar

On the very day the Federal Reserve decided to raise its target for the Federal Funds Rate from 1% to 1.25%, real interest rates in the bond market actually declined. Treasury Bond prices rose nearly one percent today dropping the yield for 30-year Treasury debt from 5.37% to 5.31%. The ten-year yield dropped today from 4.7% to 4.62%. Money is moving back into bonds, which indicates the market was overdone in anticipation of higher rates. This looks like it is shaping up to be a cat and mouse game of rhetoric and propaganda between inflation versus higher rates. We are not seeing rates go higher to cool-off a red-hot economy, but because of perceived inflation. If the perception of higher inflation can be removed, we won’t see higher rates. We will see rate increases that track “managed” inflation rates but fall badly behind the actual rate of dollar devaluation. Stagflation will somehow become the result of rising commodity and input costs versus the global deflationary pressures of inexpensive foreign labor, excess manufacturing capacity and excessive consumer debt.

To see the battle shaping up between managing inflation expectations lower and the need to raise interest rates, we can take a close look at a portion of the Fed’s statement today with my comments in brackets. First of all, even after the increase of the Fed Funds target today, the Committee believes that “monetary policy remains accommodative” [read that “inflationary”]. “The evidence accumulated over the intermeeting period indicates that output is continuing to expand at a solid pace [but slowing down per the Chicago PMI report] and labor markets conditions have improved.” [unless you are still one of the millions looking for a job!]. [Now here comes the smokescreen on inflation]… “Although incoming inflation data are somewhat elevated, a portion of the increase in recent months appears to have been due to transitory factors.” The last sentence sounds evasive about the true picture of inflation. I wish they would spell out these “transitory” forces acting on inflation, because I don’t see energy prices and other commodity prices going down very much in the near future. There is just too much global demand, especially from China, India, and other developing countries.

Stocks have been drifting sideways this week. Monday was slightly negative, but yesterday and today stocks closed with modest gains. Today the Dow Jones Industrials added 22 points to 10,435, the S&P 500 gained four points to 1,140 and the NASDAQ Composite closed higher by 12 points at 2,047. We have seen mixed guidance for the upcoming earnings season to announce second quarter results, but I’m not sure the gain in earnings will be enough to force the broad stock indices higher. I will be curious to watch the next couple days to see how much of the stock buying so far this week has been “window dressing” to close out the quarter with some decent numbers.

The U.S. dollar came under selling pressure by dropping 0.68 to 89.40 on the U.S. Dollar Index. You can see from the chart how the dollar has been waiting for the Fed decision before resuming its downtrend. With the Fed moving slowly to curb inflation, we should see the dollar soften further versus most major currencies. Some currency analysts are suggesting we will see the euro at $1.30 by year end. Tomorrow the European Union is scheduled to announce the results for interest rates from their current meeting. They never dropped as low as we have, so it is widely expected they will stand pat at 2%. If the EU fails to raise rates tomorrow it will work to slow the decline of the dollar, but not stop it. In the big picture we still need a much lower dollar to correct our enormous negative trade balance and federal deficits.

We have finally seen the beginning of the cycle to increase interest rates, but we are seeing that rates will go higher with great reluctance. We live in a credit based society that will slow down as credit becomes more expensive. The biggest and easiest gains from “wealth effect” via easy credit have seen their height. As rates move gradually higher from here, it will be up to the economy to prove just how strong and resilient it really is without the extraordinary external stimulus of cheap credit, tax rebates and increased federal spending. The market makers have managed this market sideways for the last six months as all the charts above indicate, but I still wait patiently for the longer-term primary trends to reassert themselves. With the lack of aggressive action from the Fed today, I expect the dollar to resume its decline, gold to start moving higher again, stocks to remain in a trading range before resuming their primary bear market, and bond prices to bounce slightly higher over the next week or two before resuming the long-term downtrend.

Hope you have a great evening!

Mike Hartman

Charts courtesy of StockCharts.com

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