Focus
The Economy
The second quarter was one of market volatility and strong
economic data, bounded on one end by a surprisingly strong employment report
and by an anticlimactic rate hike on the other. Since the April 2 unemployment
report, the markets have shown significant price movement. The Lehman Aggregate
Index fell 2.44% during the quarter, its worst performance since the Fed
surprised the market in the first quarter of 1994 and sparked a violent
sell-off. The 10-year Treasury note fell 4.93% during the quarter, also the
worst quarter since 1994. The yield rose 75 basis points, from 3.835% on March
31 to 4.583% on June 30 (with a high of 4.872% on June 14). According to Ryan
Labs, the shorter-term two-year Treasury note had its worst decline since the
third quarter of 1980, falling 1.3%. The yield rose 111 basis points, from
1.572% on March 31 to 2.681% on June 30 (with a high of 2.934% on June 14).
One way to view the volatility of the last quarter is that it has been the result of market uncertainty about what, ultimately, the Fed would do. To us, however, the movement in market prices was a result of market certainty about what actions the Fed would take. “We have never entered into a Fed tightening campaign with an entire rate-hiking cycle already priced in,” Merrill Lynch economist David Rosenberg wrote recently. In retrospect, the way events have played out suggests that the relationship between the bond market and the Fed is currently very close, like an old married couple that finishes each other’s sentences. It is as if the renewed emphasis on communication by the Federal Reserve has made the releases themselves part of the tightening cycle. When the FOMC statement in January changed the wording from “considerable period” to “patient”, the Fed was not making an idle word change. The market (correctly) took the word change to mean that at the next sign of economic strength, accommodation would give way to something else. The April 2nd report was that sign, and the market (again correctly) began to price in a tightening with an immediate and dramatic sell-off. The only uncertainty, if any, was whether the Fed would raise the Federal Funds rate by 25 basis points or 50 basis points. The FOMC followed suit with its “measured” statement of May 4 and the market’s call was ratified. The market positioned itself for the hike, it came, and when it did come the market actually rallied a little.
The Fed started the communication part of the next stage in the tightening cycle with the June 30 statement. The statement set forth the view that 1) even at 1.25%, the Fed Funds rate was accommodative, 2) output and resource usage had improved and 3) there have been signs recently that inflation is picking up, but these signs may be only “transitory”. In Webster’s Third, the first definition of transitory is “marked by the quality of passing away…of brief duration…” In other words, temporary or transient. The second definition is “transitional”, defined earlier as “of, relating to or characterized by transition.” Depending on which usage the Fed had in mind, then, it thinks that the recent inflation data is either temporary or it is a sign of change to come.
The change to come is what worries the Fed. The last paragraph of the statement gives the signal to the market about where, we believe, its focus will be trained in the economic data. “The Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters are roughly equal. With underlying inflation still expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.” The paragraph begins with a statement of what the Fed believes are its primary duties—sustainable growth and price stability. The paragraph ends with the Fed telling the market that even if growth is muted, it will be the inflation data that will provoke a response. In between, the Fed tells the market that whatever the response, it will be measured. If the market wants to again correctly anticipate the next Fed move, it will have to keep its eye on the inflation data. So will we.
Inflation statistics that include more direct effects of higher oil and gas prices are showing signs of strength. CPI, PPI, the personal consumption expenditures price index and the ISM input price index are all exhibiting strong price pressure. CPI is up 3.05% year-over-year, and up 6.38% in the last 3 months on an annualized basis. PPI is up 7.24% year-over-year and up 14.24% in the last 3 months on an annualized basis. Given the fact that the average price of a barrel of oil in 2003 (as measured by the nearby futures contract) was $30.99 and that the average price of a barrel of oil in the first six-months of 2004 has been $36.78, we can expect to see these inflation measures to continue to look strong.
We aren’t certain that oil is the only item driving inflationary pressures. Energy-related items only account for 7.1% of the CPI (but it is up 14.33% year-over-year and 29.73% in the last 3 months on an annualized basis). Looking back to May 2003, when oil prices began to rise, CPI and the PCE were actually falling. Today, with oil prices sticking at historically elevated levels, even backing out the more volatile food and energy costs reveals an inflationary trend. Transportation and medical care, which together comprise 23% of the CPI index, are both rising faster than the base CPI rate. The Consumer Price Index less food and energy is up 1.76% year over year, but in the last 3 months and 6 months it has risen at an annualized rate of 3.33% and 2.49%, respectively. “Over the past six months,” writes consulting economist James A. Bianco, “the difference between the Targeted Fed Funds Rate and All Urban CPI is at its lowest level (largest negative real rate) since February 1975….Looking at the past 6 months of the Core CPI (the economist’s favorite measure of inflation) versus the Targeted Fed Funds Rate yields similar results. The Fed Funds Rate is further below Core CPI than it has been since June 1980.”
To bring all of this back to our investment strategy, it is worth pointing out that the spread between Fed Funds and the 10-year on March 31 was 283 basis points. At June 30 it was 333 basis points. The market clearly still believes that there are more Fed Funds increases in our near future, a view that we share. However, we still will watch with the market the basic economic data which tracks resource usage as an indicator of economic growth—primarily capacity utilization and nonfarm payrolls—but the PPI and CPI numbers, due out next in mid-July, will likely carry greater impact than earlier in the current economic cycle. Volatility will likely surround the release of these important economic statistics.
The Mortgage Market
Mortgage prepayments slowed considerably for the month of
May (June reporting period), with aggregate speeds declining by about 27% from
April’s numbers. The slowdown in prepayment speeds is likely to continue over
the next few months as the start of the Fed tightening cycle hampers the
borrower’s refinancing incentive. Further, leading prepayment indicators also
point to slower speeds for the summer. For example, the MBA Refinancing index
continued its downward slide, declining by 12.4% on the month to 1387, and
Freddie Mac’s Primary Mortgage Market Survey Commitment rate, although
declining slightly during the month to 6.25%, is still well above the lows of
5.4% reached during the mini-refinancing wave of the first quarter of 2004.
That being said, it remains to be seen how slow prepayments will go as alternative mortgage loan products and a strong housing market make available a range of opportunities for mortgage borrowers looking to refinance and purchase homes. Freddie Mac research reports that 50% of some mortgage originators’ production is now in products other than pure fixed rate. Also, the MBA purchase index is close to record high levels even as house prices continue to rise (up 7.7% year-over-year for 1Q 2004 as measured by OFHEO’s housing price index). Thus, along with the level of interest rates, the majority of Wall Street research is looking for the strength of the housing market and the mortgage lender’s ability to offer alternative products for home financing to drive the prepayment story in the near term. This is certainly something we will monitor closely going forward.
The Markets
In June, the bond
market leveled off, but the high and low close for the month tells a story,
with the short end of the curve having the bigger percentage swing. Stocks continued
to nudge up, as investors focused one earnings reports and the growth part of
the economic picture. The dollar weakened slightly, gold traded in a range. In
the oil market, prices seemed to have stabilized, albeit at higher levels.
