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Market Commentary
Last month's employment figures were within predicted levels but upward revisions to the nonfarm payroll numbers in the preceding two months dimmed prospects of another Fed rate cut at the end of the month. Though lower borrowing rates would also benefit stocks, the stronger than expected labor situation means businesses are still expanding and more wage earners mean more consumer spending.
The employment report trumped all other influences and by the end of stock trading, the Dow had gained 0.66% on the day; the S&P 500, 0.96%; and the Nasdaq, 1.71%. All three made solid gains for the week, a fourth consecutive advance. The Dow rose by 1.23%, the S&P 500 by 2.02%, and the Nasdaq by 2.92%.
The S&P 500's close today was a record high and the Dow's was its second highest on record. The Nasdaq's close was the highest since February 1, 2001. In the bond market, the yield of the benchmark 10-Year Note, despite rising by 12 basis points today, was up by only 4 basis points for the week. This follows a decline of 3 basis points last week. Yields move inversely to price.
Next week, the economic calendar is back-weighted. There are no economic releases slated for Monday and the bond market will be closed in observance of Columbus Day. There are no economic reports on Tuesday either but in the afternoon, the Federal Reserve will release the minutes of its last monetary policy meeting, held on September 18.
Between January of 2001 and June of 2003, the Federal Open Market Committee (FOMC, the monetary policy arm of the Fed) reduced the short-term lending rate between banks (fed funds rate) from 6.50% to a decades-low 1.00% in order to reduce general borrowing costs and stimulate the economy. But between June of 2004 and June of 2006, the FOMC raised rates fourteen times to 5.25%. The rate remained there until last month when the committee cut the rate by 0.50% to 4.75%.
In the meetings between the last rate increase and September's rate cut, the FOMC had said that its primary concern was with the threat of inflation. In the meetings just prior to last month's, the committee said that though it expected elevated inflation levels to abate over time, the possibility that they might not abate as expected was keeping the Fed in a wait-and-see stance regarding rates.
But the troubled housing and mortgage industries jolted the credit market since it caused investors to back away from risky mortgage debt. Consequently, lenders in general have tightened loan standards, making it harder to borrow money. In the meantime, holders of mortgage loan products are in a bind since buyers are scarce. This bottleneck reduces the amount of money flowing through the monetary system and drives up the cost of borrowing.
With the complex network of risk-sharing in the world markets, the situation has become wide-spread. In August, France's largest bank froze three of its hedge funds, not allowing investors to add to or liquidate their holdings. The incident prompted central banks in numerous countries to make short-term loans to banks in order to keep money flowing and ease investor anxiety.
The Federal Reserve was one of the banks pumping additional reserves into the monetary system. It even made a 0.50% cut to the discount rate in August. The discount rate is the rate banks must pay for loans directly from the Fed. In addition, the committee extended the length of time reserves could be borrowed and it made a public relations push to diminish the negative connotations attached to such borrowing (loans from the Fed were typically considered last resort measures).
Nevertheless, short-term commercial debt offerings dried up and investors flocked to the safety of government backed securities (Treasuries). In order to ease the credit situation, the Fed made another 0.50% cut to the discount rate and cut the fed funds rate last month.
The bond market, which normally benefits from rate cuts, took a hit after the Fed action. For one thing, it eased the flight-to-safety flow that had been generated by the credit situation. For another thing, the aggressive actions were seen as potentially inflationary. But, after the initial reaction played itself out, prices of Treasuries trended higher once again -- until today's meltdown.
Fed watchers will be very eager to see if the minutes of the September meeting shed any light on the committee's assessment of the inflation threat and the effect on it that the cuts might make. They will also be interested to see if August's employment report was mentioned as a contributing factor in the committee's decision to cut rates.
The only major economic release on Wednesday is the report on wholesale inventories for August. The release is considered second-tier since the wholesale category is only one part of the inventory picture and the data is somewhat dated. In July's report the Commerce Department said that the seasonally adjusted level of wholesale inventories rose by 0.2%. This was lower than forecasters were calling for and June's previously reported gain of 0.5% was revised down to 0.3%. Moreover, July's gain was the weakest inventory reading since a 0.3% decline was posted last December.
Sales also slowed in July, growing by just 0.1% after a 0.4% increase in June. Yet, inventories remained lean. The inventory-to-sales (I/S) ratio came in at a record low 1.11 for a third consecutive month. The I/S ratio is the value of remaining inventory divided by the value of sales for the month. The result indicates how many months it would take to entirely deplete stocks on hand. A low ratio indicates strong pressure to replenish supplies.
Inventory gains are expected to have been sluggish again in August with a projected increase of 0.2% or 0.3%. The I/S ratio is still expected to indicate lean supply levels, however.
Besides the inventories report, traders will also have a couple of minor, weekly reports to consider. These are the oil inventory report from the Energy Department and the application index data from the Mortgage Bankers Association.
The release schedule heats up on Thursday. The jobless claims report will highlight the employment situation once again. In yesterday's report, the Labor Department said the seasonally adjusted level of initial claims for state unemployment benefits rose by 16,000 last week to 317,000. The increase was a little stronger than analysts had anticipated but they were looking for a move higher after a net decline of 36,000 over the previous four weeks. The four-week moving average, which smoothes out some of the short-term volatility, was up by just 500 to 312,750. For the year to date, the average weekly level has been 317,564.
The report said that continuing claims for the week ending September 22 (continuing claims must be at least a week old) declined by 10,000 to 2.541 million. The four-week moving average fell by 12,750 to 2,557,250. This was still up from the weekly average for the year to date of 2,530,474.
Little change is expected in this week's claims level but given the larger than expected rise in the last report, a slight pull-back would not be too surprising.
Two trade-related reports are also slated to be released on Thursday morning. These are the report on international trade for August and the report on import / export prices for September. In the last report on the balance of trade, the Commerce Department said that the seasonally adjusted value of imports exceeded that of exports in by $59.2 billion in July. This was a slightly narrower monthly deficit than June's $59.4 billion gap but June's figure was sharply revised from its originally reported $58.1 billion. In fact, data revisions going back to the beginning of the year resulted in larger deficit readings in every month except April.
The report indicated that the value of exports surged by 2.7% in July to a record high $137.9 billion. This was the largest jump since March. But the larger category of imports rose by 1.8% to a record high $196.9 billion.
August's trade gap is expected to be slightly narrower than July's. The consensus prediction is for a deficit of $59.0 billion but some analysts have predicted a gap as small as $58.5 billion. Since net exports constitute a component of gross domestic product, a larger gap figure would translate into a larger deduction from GDP and a smaller deficit would translate into a smaller deduction from GDP.
The report on import and export prices gives some indication of inflation pressures stemming from the trade situation so observers usually focus on the import sector. In the last report the Labor Department said its index of import prices fell in August by 0.3%, the first decline since January. While oil played a part (the price index for petroleum products fell by 1.3%), the decline was broad-based. Even excluding oil, import prices were down by 0.1%. Moreover, July's originally reported overall gain of 1.5% was revised down to 1.3% and the originally reported ex-oil increase of 0.2% was revised to a rise of just 0.1%.
On the export side, prices were up by a 0.2%. The large but volatile category of agricultural products rose by 1.0% but excluding the category, export prices were up by 0.1%. July's originally reported overall gain of 0.2% was revised to a decline of 0.1% and a flat reading (0.0%) excluding agriculture was revised to a decline of 0.2%.
According to the Energy Department, average spot oil prices moved sharply higher last month. Consequently, a rise in the import price index is anticipated. Forecasts are between 0.5% and 1.0%.
Supply may generate some resistance for the bond market on Thursday morning as traders position for the Treasury's auction of 10-Year Treasury Inflation Protected Securities (TIPS). TIPS have a fixed coupon (interest) rate, but their face value is regularly adjusted according to the Consumer Price Index, so the interest payout amounts fluctuate according to the changes in inflation. At maturity, the greater of the inflation-adjusted or original redemption value is paid out.
In the current auction schedule (begun in July of 2003) a new 10-Year TIPS issue is offered twice a year but three months after each initial offering, an additional amount of the issue is sold so there are two initial and two reopening auctions each year. Next week's offering is a reopened of July's issue and the last such auction had a face value of just $6 billion, the lowest offer size for a 10-Year TIPS reopening in the current issue schedule.
The last reopening auction in April was weak. Bids exceeded the $6 billion offer amount by 1.88 to 1, the lowest bid-to-cover ratio for a reopening of the security in three years. Noncompetitive bids, a gauge of individual investor demand, totaled $27 million, the lowest amount for any 10-Year TIPS offering since October of 1998. Foreign demand was extremely light. Indirect competitive bids, which include those from foreign central banks, received just 18.6% of the issue. The average award in this bid category in the previous six reopenings was 47.1%.
But July's initial offering was well-received. The bid-to-cover ratio was 1.97, the highest for an initial offering of the security since January of 2004. Noncompetitive bids totaled $71 million, the largest amount in an initial offering since last July. And indirect competitive bids garnered 43.4% of the issue, the largest portion of an initial sale since January of 2006.
Later Thursday afternoon, the Treasury is scheduled to release its budget figures for September. But, since September marks the end of the 2007 fiscal year, the report may be delayed due to auditing activity. In September of 2006, receipts exceeded government outlays by $56.3 billion. Forecasters predict that last month's bottom line will be a larger surplus of around $100 billion. One of the reasons for the projection is that August's reported deficit of $117.0 billion was much larger than estimates at the time of an $85 billion deficit. Some of the variance may have been due to calendar issues which are expected be compensated for in September's numbers.
If the current prediction is accurate, this would result in a total deficit for the 2007 fiscal year of $174.3 billion. This compares favorably to the $248.1 billion deficit in fiscal year 2006. In fact, it would be the smallest yearly deficit in five years. Lower deficit figures are a plus for bonds since they mean the Treasury will not have to issue as many debt securities (Treasuries) in the future.
Friday's slate of economic releases contains a couple of heavyweights. The report on retail sales will indicate the strength of consumer buying last month. In August's report, the Commerce Department said that the seasonally adjusted level of sales rose by 0.3%. Though this fell short of predictions of a 0.5% gain, July's originally reported increase of 0.3% was revised to a gain of 0.5%.
Auto sales showed strength in August, rising by 2.8%, the largest increase since September of last year. But excluding this sector, sales were down by 0.4%, the largest ex-auto drop since September of 2006. A major contributor to the weakness was the category of sales at gasoline stations. Though lower gas prices were expected to result in lower sales totals, the decline was a larger than anticipated 2.4%, a third consecutive monthly drop and the largest since last October. Excluding both the auto and gas station categories, sales were 0.1% lower in August following an 0.8% increase in July.
For September, overall sales are expected to have risen by 0.2% and ex-auto sales by about 0.3%. Some analysts are looking for stronger sales figures, though.
The other major release on Friday is the Producer Price Index (PPI) data for last month. In the last release, the Labor Department said the PPI, a gauge of inflation at the wholesale level, fell in August by 1.4%, the biggest decline since last October and a much bigger drop than the 0.1% analysts were predicting. As expected, the primary reason for the decline was a drop in energy prices, the index for which fell by 6.6%. This was the largest decline since April of 2003. Another volatile category, foods, also saw a price index contraction of 0.2% -- a fifth consecutive monthly decline.
But excluding these two categories, prices of finished wholesale goods rose by 0.2%. While this was an in-trend core reading and not a major inflation alarm, it came after a 0.1% reading in July and was a little higher than analysts were expecting. On a year-over-year basis, core prices were up by 2.2%, a little less than July's Y/Y increase of 2.3%, but it was still the second highest reading since September of 2005.
Forecasts for September call for an overall increase in the PPI of about 0.5% and an increase at the core level of about 0.2%.
The report on business inventories for August will also be released on Friday. July's report was more bullish than expected. In it, the Commerce Department said that the seasonally adjusted level of inventories rose by 0.5%. Previously released reports on manufacturing and wholesale levels showed 0.2% gains in those categories. The only unknown at the time of the business inventories report was the level of inventories in the retail category. July's report said they rose by 1.0%, the largest jump since May of last year.
Sales were also strong in July, rising by 1.1% following a 0.3% decline in June. The combination of inventory levels and sales pushed the I/S ratio down to 1.26 from June's 1.27. July's reading was only slightly higher than the record low of 1.25.
The latest factory orders report said that manufacturers' inventories were down by 0.1% in August and the forecast for the wholesale sector is for a gain of 0.2% or 0.3%. Despite July's spike in retail inventories, the average monthly change for the year so far is only an increase of 0.3%. If these values are plugged into the weighted calculation of total inventories, it produces a gain of 0.1%. But analysts are apparently looking for another above-trend increase in the retail category since the consensus prediction is for a gain of 0.3%. In any case, the I/S ratio is expected to remain low.
The final economic item on next week's calendar is the initial read on consumer sentiment for the month from the surveys conducted by the University of Michigan. According to news sources, the final index reading for September came in at 83.4, down from the preliminary reading of 83.8 and matching August's final figure as the lowest since August of last year.
The expectations index slipped to 74.1 from the preliminary reading of 74.4 but this was still better than August's final read of 73.7. But the index of current conditions fell to a twelve-month low of 97.9 from the preliminary 98.3 and August's 98.4.
The preliminary September index is expected to reveal an increase in optimism as higher stock prices improve household wealth and lower interest rates increase buying power and brighten the economic outlook.
10:30 AM EDT : Bond traders did not like this morning's employment report for September and Treasuries are down sharply. Stocks are up but gains there have been relatively mild because of the mixed nature of the news and the fact that price levels are already high.
Although the seasonally adjusted level of nonfarm payrolls rose by 110,000 last month as expected, August's originally reported decline of 4,000 was revised to a gain of 89,000 and July's previously reported gain of 68,000 was revised to 93,000. The stronger numbers are bullish for the economy and argue against the Fed cutting rates.
Another negative for rate cut prospects was a 0.4% increase in average hourly earnings in September following two months of 0.3% increases. The earnings figure is an inflation indicator and aside from the rate implications, high inflation undercuts the present value of bonds since it means interest and principal payouts in the future will be made in less valuable dollars.
In the goods producing sector, construction payrolls fell by 14,000 and manufacturing fell for a fifteenth consecutive month with a decline in September of 18,000. In the services sector, the biggest gainer was education and health, which saw payrolls increase by 44,000. This marked three years of consecutive monthly expansions in that category. The next highest gainer was in leisure and hospitality services where payrolls grew by 35,000, a twenty-third consecutive gain. Payrolls in business and professional services gained 21,000 jobs.
There were weak spots in services, however. Financial activities -- which include finance, insurance, and real estate -- saw a net loss of 14,000 last month, matching August's decline. Retail trade saw a decline of 5,200.
A key category behind the revisions to July and August was government employment. July's previously reported decline of 52,000 was trimmed to 28,000 and August's originally reported decline of 28,000 was revised to an increase of 57,000. In September, government payrolls grew by 37,000.
Despite the increases in payroll, they were not enough to prevent the unemployment rate from edging up to 4.7%. Though still considered low, the rate is the highest since August of last year. The unemployment rate is the portion of the workforce (over 16 years old and actively seeking employment) without jobs. While the number of jobs can increase, so can the workforce. Today's report said that it rose by 573,000 individuals in September after falling by 340,000 in August.
The report is especially significant since August's reported decline was seen as an important influence on the Fed's decision to cut rates at the last policy meeting on September 18. The improved assessment of the labor situation therefore diminishes expectations for another rate cut at the next meeting slated for the 30th and 31st of this month.
The bond market's reaction to the jobs report may be getting an extra nudge due to a reduced trading window today. The Securities Industry and Financial Markets Association (formerly the Bond Market Association) has recommended an early (2:00 PM EDT) close today ahead of the Columbus Day weekend. The bond market will be closed on Monday though the stock market will remain open.
In the stock market, the bullish economic implications of the payroll number are currently the focus of attention. Traders are even discounting negative guidance from Merrill Lynch and Washington Mutual this morning as backward-looking data that will be followed by improvements in the current quarter. Another supportive factor is a decline in oil futures. In recent trading, the price of a barrel of crude oil for November delivery was down by $0.57 to $80.87 . . . .
source: Lion, Inc.
