While inflation seems relatively stable at the moment, the future remains uncertain. In our earlier discussion, we touched upon a compelling new report that’s gaining traction. It reinforces the idea that individuals can influence their own monetary destiny, particularly in an era where fiat currencies dominate and the gold standard feels antiquated. If central banks succeed, as seen in recent years, in managing inflation through wise monetary policies, they can also falter, as indicated by the economic landscape of the early 1980s. It’s possible that the Federal Reserve and its global counterparts will maintain their success indefinitely. However, predicting the long-term outcome is challenging. Such is the nature of economies governed by human decisions.
Although it wasn’t the most opportune day for an optimistic discussion about inflation, two Federal Reserve officials were out on the speaker circuit on March 23, sharing their thoughts on the advantages of informed monetary policy. Philadelphia Fed President Charles Plosser addressed a bankers conference, stating, “I predict that the yield curve will, on average, be flatter than in previous business cycles. This doesn’t imply a constant inversion, but generally speaking, I believe the curve will flatten out.” He attributed this expectation to reduced volatility in inflation forecasts, asserting that, “My rationale for a flatter yield curve is founded on two premises: firstly, inflation and its expectations are likely to be lower and more consistent, resulting in a diminished inflation premium relative to the past; and secondly, both inflation and economic activity should show less volatility, thus reducing the risk premium.” While Plosser isn’t convinced that an inverted yield curve will become a constant feature, he expressed confidence that inflation in the U.S. will remain both low and stable, which implies that the rationale for long-term rates to exceed short-term rates is weaker.
Financial news can often lead to confusion, and this week was no exception. Amid the Federal Reserve’s FOMC statement and various economic indicators, the data seems to fit any narrative one wishes to pursue. Nonetheless, while the economy remains somewhat ambiguous, market behavior is ever precise. Economists may hedge their predictions, but traders are forced to articulate their sentiments through numerical values, whether optimistic or pessimistic. Ultimately, market prices dominate the discussion. They can prove accurate, erroneous, or somewhere in between, but without foresight, we cannot ignore the current asset pricing trends.
With this perspective, let’s take a quick assessment of the recent market landscape across various asset classes. Notably, there’s a troubling trend of losses relative to prior history. According to the table below, Real Estate Investment Trusts (REITs) have seen the steepest decline this past month, shedding 5%. However, they still boast significant gains year-to-date, showcasing their remarkable resilience in the 21st century. While it’s uncertain if REITs can weather future storms, they appear increasingly exposed to ongoing economic and real estate uncertainties.
Another sector to watch is emerging markets, which have dipped nearly 2% over the past month. Like REITs, emerging markets have impressive year-to-date returns, but given their high-risk nature, vigilance is key. In fact, every asset class has faced declines recently except for U.S. bonds, TIPS, and cash. This widespread selling signals, at least to us, that attaining positive returns may not come easily moving forward. We may be entering a new era characterized by elevated risks and potentially diminished returns compared to recent years. Although current returns might seem deceptively promising based on last year’s performance, investors must remain aware that recent trends can cloud perceptions of future outcomes.
Indeed, across different asset classes, diversification remains a smart long-term strategy. However, it offers no guarantees. The risks associated with configuring the right blend of asset classes are on the rise. Still, since there’s no alternative to holding diverse investments for the long haul, strategic investors must face this challenge. To quote Churchill, asset allocation may be the least unfavorable strategy when compared to all others.
Yesterday’s surge in equity and bond prices was noteworthy. Following the Fed’s FOMC announcement that interest rates would remain steady, buyers entered the market with enthusiasm. In the last two hours of trading yesterday, the S&P 500 rose by 1.7%, while the yield on the ten-year Treasury fell to 4.52%, marking its lowest point in over a week. Yet, instead of signaling an end, this session kicked off new speculation about the next stage of a business cycle that appears increasingly elongated. As highlighted in comments from Gail Fosler, chief economist of The Conference Board, even though the economy continues to expand, there are early warning signals to note, especially regarding inflation: “The factors impacting corporate profitability will likely turn more unfavorable as we progress through 2007,” Fosler cautioned. “Deteriorating productivity coupled with rising costs does not paint a rosy picture for the future.”
Despite this, investors yesterday were optimistic. For bond traders, optimism was fueled by the Fed’s acknowledgment of an economic slowdown. In the FOMC statement, the bank noted: “Recent indicators have been mixed, and the adjustment in the housing sector remains ongoing.” Furthermore, bond buyers focused on the absence of “additional firming” in the language, previously present in earlier statements on monetary policy.
However, did buyers overlook other critical portions of the FOMC statement? For example, this line raises concerns regarding bond ownership: “Recent core inflation reports have been somewhat elevated. Although inflationary pressures are likely to moderate over time, the high level of resource utilization could sustain these pressures. Under these conditions, the Committee’s primary concern remains the risk that inflation will not moderate as anticipated.”
Interest rates remain unchanged, but the Fed’s concerns about rising core inflation are evident. We can take that as a cue.
For now, uncertainty about the future opens doors for short-term market fluctuations. As the Fed indicated, “incoming information” will dictate future actions. Nonetheless, it appears the central bank is bracing for a possible tightening if inflationary trends continue. Yet Mr. Market seemed to have different priorities yesterday. Optimism often prevails when given a choice. Is it justified? Or was yesterday’s buying merely a case of irrational exuberance?
All indications suggest the Federal Reserve is unlikely to announce any interest rate cuts during today’s FOMC meeting. Current sentiments align with Fed funds futures, which show an April contract firmly set at 5.25%. However, predictions for the end of the year hint at lower rates. Nonetheless, this does not provide immediate relief.
“The most probable outcome is no change,” said Jim Russell, director of core equity strategy for Fifth-Third Asset Management in Cincinnati, as quoted in the Mercury News Wire. “We may receive insights into the national housing market, but substantial action seems unlikely.”
Conversely, there are those seeking reassuring language from the Fed in light of the turbulence enveloping the subprime mortgage sector. “Market uncertainty surrounding the trajectory of the U.S. economy is palpable,” remarked Oscar Gonzalez, economist at John Hancock Financial Services, as reported by AP via The Baltimore Sun. “I believe the Fed’s message will focus on stability.”
The pressing question is: What constitutes enlightened stability in today’s monetary policy environment? Martin Crutsinger, economics writer for AP, highlights the Fed’s dilemma in his column today.
…the economy has weakened with business investment, which had been expected to compensate for a faltering housing sector, now declining. Additionally, consumer spending is also showing signs of weakness. As a result, some economists have raised the chances of a recession this year, with Greenspan estimating a one in three probability. Typically, the central bank would respond to deepening economic weaknesses with interest rate cuts. However, two recent inflation reports indicated that both wholesale and retail prices have accelerated in February.
Ed Yardeni, CIO of Yardeni Research, recently shared his economic outlook in a client email. “Real GDP growth is expected to remain subdued throughout the first two quarters of 2007,” he noted. “The main culprit is residential investment, which detracted a full percentage point from real GDP growth in the last two quarters of 2006 and is likely to do the same for the first two quarters this year.”
If rates remain steady amidst a slowdown and persistent inflation concerns, today’s goal will be to carefully analyze the FOMC statement for insights on future monetary policy. Additionally, we will be watching tomorrow’s jobless claims report and Friday’s update on existing home sales from February closely.
We rely on data, but right now, there’s little new information available for analysis.
A collective sigh of relief seems to resonate. Following the morning’s update on housing starts for February, there’s a faint glimmer of hope regarding the real estate outlook for 2007. While it may be a fleeting moment, it provides a spark of optimism for now.
The Census Bureau reported that the number of newly constructed privately owned housing units rose by 9% last month compared to January, adjusted for seasonality. In actual figures, this translates to 1.525 million new starts in February. As illustrated in the chart below, this development offers a much-needed boost to the struggling housing market.
The anxiety stemming from last week’s resurgence of inflation fears and this week’s Federal Reserve FOMC meeting means that speculations around price trends will dominate the markets this week.
Triggered by the news, the gold market has begun to rise again. Meanwhile, the dollar is experiencing some decline, as indicated by the U.S. Dollar Index.
This uncertainty is also affecting equity markets. The S&P 500 has shown sideways movement lately, waiting for clearer guidance on upcoming developments in the week. The market for the benchmark 10-year Treasury Note has also become more cautious, as inflation has re-emerged as a critical issue for discussion.
Today’s inflation report may not please Mr. Market. Consumer prices rose by 0.4% last month, double the January increase and higher than the anticipated 0.3%.
According to the Bureau of Labor Statistics, the consumer price index increased by 2.4% year-over-year through February. While a 2.4% annual inflation rise may not be alarming at first glance, further analysis of underlying data reveals concerning trends.
When examining the core inflation rate, which excludes volatile food and energy prices, it becomes clear that the core CPI has jumped to an annual rate of 2.7% as of February. This is alarmingly close to the Fed’s target range of 1% to 2%. Notably, the last time the core CPI comfortably fit within the Fed’s target was in August 2004.
More worrisome than the current figures is the persistently upward trend: core CPI has been steadily climbing for nearly three years. This trend serves as a significant warning signal. While any singular month may not reveal dramatic shifts, over time it shows a clear tendency for core inflation to trend higher, as illustrated by our chart below.
But does it truly reflect a long-term trend? The uncertainty remains. However, recent evidence suggests a gradual upward momentum in inflationary pressures.
Addressing this momentum is typically within the remit of central banks, which are expected to tighten monetary policy in response. The pressing question is whether the Fed feels equipped to take such action given the current slowing economy. Raising interest rates may be met with considerable resistance across various sectors. Yet, it’s worth noting that central bankers are responsible for results rather than popularity.
Last June, Bernanke’s Fed elevated Fed funds by 25 basis points, reaching 5.25%. Currently, it’s unclear what the Fed’s strategy will be moving forward, aside from reading public signals. Nonetheless, one certainty remains: Bernanke and his team will be re-evaluating monetary policy in the lead-up to next week’s FOMC meeting.
This morning’s update on February wholesale prices presents a critical chapter for the Federal Reserve to consider.
The ongoing climb in core producer prices last month further hints at increasing inflationary pressure building within the manufacturing sector. It’s possible this is merely a temporary fluctuation, but until subsequent reports confirm otherwise, it would be prudent for monetary policy to err on the side of caution. Containing inflation once it takes root is far more challenging than preventing it from emerging.
Regarding today’s PPI figures, the overall PPI surged by 1.3% in February, the highest increase since last November and among the most pronounced monthly spikes in recent years. On an annual basis, the PPI is now climbing at 2.6%, the highest rate we’ve seen since last summer. The previous respite from rising wholesale prices observed from last July to October now seems to be dissipating.
While it’s tempting to attribute this latest price increase solely to energy prices, the facts demand a broader view. Energy costs indeed jumped by 3.5% for finished goods last month, nearly negating the 4.6% decline seen in January. However, when you exclude food and energy costs from the PPI, there’s still cause for concern. The core PPI advanced by 0.4% last month, double January’s growth rate. On an annual basis, core PPI is progressing by 1.8%. This isn’t catastrophic, but it’s a significant increase from the previous summer. The question that remains is whether this momentum will persist.
It’s premature to consider interest rate hikes, yet equally early to consider cuts. For now, we await tomorrow’s consumer price report for February for more clarity on price movements. Having analyzed the latest PPI data, we will approach the CPI update for February with heightened skepticism.
In the wake of yesterday’s stock sell-off and fresh anxieties surrounding subprime mortgages, you may have overlooked the latest updates from the International Energy Agency. They recently warned that crude oil inventories in developed nations are on track to plummet to the lowest levels in a decade, which signals a potential intervention from OPEC.
The report indicates, “Preliminary data suggests that OECD stocks have fallen by over 1.26 million barrels per day over the first two months of the year. We might be heading towards the most significant first-quarter stock reduction in over a decade.” Hence, the IEA recommends that OPEC boost production in the coming months to accommodate demand pressure.
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