What a Week: Hard Sell
Liz Rappaport
12/01/06 - 05:40 PM EST
A report showing that U.S. manufacturing contracted in November shook up the stock, bond and currency markets Friday, as expectations for rate cuts and recession dominated a week thick with data and Fedspeak.
Markets had foundered through the week as the reams of data and Fed speeches rolled in. But investors were aligned by Friday morning in their fears that the economy's landing will be harder rather than softer. Stocks dropped, Treasury bonds rallied sharply and the dollar weakened. Amid all the signs of slow growth, Fed speakers retained their focus on inflation as key to their assessment of monetary policy.
Treasury bonds reacted most to the week's data gyrations, driving yields down to lows not seen since January. The move may be extreme, but not unfounded in its direction as reports came out showing weak new-home sales, lackluster retail sales in November, weak durable goods orders and contracting manufacturing activity.
The 30-year Treasury yield finished the week at 4.55%, down from 4.63% last Friday. The 10-year note also rallied sharply, bringing its yield to 4.43%, down from 4.55% last Friday. And the two-year note also ended the week yielding 4.52%, down from 4.73% last week.
For the week, the
Dow Jones Industrial Average shed 0.7%, closing at 12,194.13 Friday after trading as low as 12,090 intraday. The
S&P 500 ended the week down 0.3% to close at 1396.71 Friday, and the
Nasdaq Composite fell 1.9% on the week to close at 2413.21 after trading as low as 2393 intraday. Weakness in semiconductor stocks such as
Nvidia (NVDA) and optical networking stocks such as
Finisair (FNSR) paced the Comp's 0.8% slide on Friday.
The Dow Jones Transportation Average ended the week down 2.9% as the price of oil kept climbing to back above $63 per barrel Friday. Energy stocks such as
Exxon Mobil (XOM) did benefit from oil's rebound, helping the S&P 500 outperform the Dow and Nasdaq for the week.
Other economically sensitive sectors had a tough go of things as well. The retail stocks did not benefit much from Thanksgiving shopping news as the
S&P Retail Index dropped 1.2% on the week amid continued weakness in industry bellwether
Wal-Mart (WMT). Also,
Federated (FD) slid 3.5% in heavy volume Friday after a Citigroup downgrade although
Home Depot (HD) was buoyed by speculation it may be the target of a private equity buyout.
Homebuilders such as
Pulte Homes (PHM) on the other hand, took off as their tie to low interest rates gave investors hope that the housing market will not collapse further. The
Philadelphia Housing Sector Index jumped 2.9% on the week.
But with Treasury yields at levels far below the 5.25% fed funds rate, bond traders expect more than one rate cut in the first half of next year. Many strategists find it difficult to suggest investors jump into Treasuries at these levels, but investors are out there buying despite the warnings.
"We think the market has gotten a bit ahead of itself," says Andy Richman, fixed-income strategist in SunTrust's Personal Asset Management Division. "This is not a place to rush in."
Federal Reserve chairman Ben Bernanke and other Fed presidents seem to agree. Repeatedly this week, Fed officials reminded investors this week that inflation remains "uncomfortably high," as if attempting to pull back the Treasury bond market from expecting an ease in the first part of 2007.
The week's data leaned heavier on the negative growth prospects, but did support some concerns about inflation. Even in the Institute of Supply Management report, which read 49.5 (any reading below 50 reveals a contraction), the prices-paid index was higher than expected, revealing some inflationary pressure still in the mix. Likewise, the core personal consumption expenditures deflator came out higher than expected, leaving core inflation at 2.36% year over year -- above the Fed's 1% to 2% comfort zone.
Bernanke spoke again Friday, but did not comment on monetary policy. Chicago Fed President Michael Moskow did comment, however, ignoring the weak ISM report and hinting at further rate hikes. "Some additional firming of policy may yet be necessary to bring inflation back to a range consistent with price stability in a reasonable period of time," says Moskow.
Philadelphia Fed President Charles Plosser also spoke Friday and reportedly downplayed the ISM report in comments to reporters. Plosser said he is more concerned about inflation than economic growth, according to newswire reports.
So, either the bond market is ahead of the Fed in pricing in a deep economic fall, the Fed doesn't see the same doom and gloom, or the Fed just isn't ready to signal a rate cut yet.
"The Fed is in a bind," says Ethan Harris, chief economist at Lehman Brothers, harkening back to 1995 when the Fed overshot its tightening campaign and had to cut rates later. But in 1995, the economy was slowing more rapidly than it is now, writes Harris. So with history as a guide, the Fed would need to see much slower growth and an abating of inflation pressures to contemplate a rate cut.
Regardless, the fed funds futures market is pricing in 31% odds of a cut in January, up from 14% on Thursday, according to Millrr Tabak. For March, odds of a cut are 70%, up from 40% Thursday. The market prices in a 31% chance of a second rate cut in May.
"The decisive moment for the
Fed-bond market tug-o'-war may not come until late winter, when evidence begins to accumulate one way or the other about a reversion toward trend growth or a deepening slowdown," writes Neal Soss, economist at Credit Suisse.
So into December we go, with the markets expecting a hard landing for the economy and the Fed still preaching soft landing and warning of rate hikes.
