In the calm before the storm
Tuesday , the markets were sanguine ahead of the year's first Fed Open Market Committee meeting and a deluge of data. As the data streams in Wednesday morning, traders are letting their nerves show. For good reason -- economic growth accelerated at faster-than-expected 3.5% pace in the fourth quarter of 2006 and that's with a growing drag from the residential housing market. Housing activity fell 19.2%, topping the third quarter's 18.8% decline. The consensus had expected growth at 3% in the fourth quarter. The data brings the pace of growth for all of 2006 to 3.4%, greater than the 3.2% growth in 2005. "What slowdown?" quips Michael Darda, chief economist at MKM Partners. Major averages struggled Wednesday morning on the news as faster growth gets investors inflation and rate hike fears up and running. The S&P 500 and the Nasdaq Composite are in the red, but the Dow Jones Industrial Average is up marginally in recent trading thanks to strength in Boeing ( BA) following its stellar earnings report. Breaking down the figures, consumer spending increased 4.4% in the fourth quarter, up from 2.8% in the third. Government spending also increased 3.7%, and defense spending added 12%. Housing's 19.2% fall was the largest since 1991, and it is down for five straight quarters. Indeed, housing dragged GDP down 1.2% in the fourth quarter. Investment in equipment and software was also weak, and the unsung hero was trade. Exports jumped 10% in the quarter compared with 6.8% in the third. Imports decreased 3.2% in the fourth quarter.
Inflation-wise, the numbers were benign. Core personal consumption expenditures came in at a 2.1% pace of growth for the fourth quarter, lower than the 2.2% third quarter reading. Likewise, the fourth-quarter employment cost index Wednesday morning showed a 0.8% increase, lower than the 1% analysts expected. Nevertheless, investors are concerned about inflation from rising wages and above-trend economic growth. The risk premium on inflation-protected Treasury notes is creeping up, notes Randy Diamond, trader at Miller Tabak. Friday's payrolls report for January, which provides a read on average hourly earnings, will offer more insight into wage inflation. As for what GDP means to the Fed, the markets still expect no change in rates Wednesday. But traders expect the policy statement will be more hawkish than those of recent meetings, mostly to acknowledge stronger fourth-quarter growth and signs of stabilization in the housing market. Indeed, "if you take housing out of the equation, you have a booming economy, inflation running higher than the Fed's 'comfort zone,' a strong consumer, wages pushing higher and unemployment running at full employment," says Marc Pado, chief market analyst at Cantor Fitzgerald. "Under those circumstances, the Fed will be scratching their head to find a reason not to raise rates." Darda notes that if you remove housing and autos, the economy grew at 6% pace in the fourth quarter.
Raising the hawkish rhetoric may have more weight for the markets with the stronger-than-expected GDP number in hand. At 2:15 p.m. the FOMC will release its statement. As it stands, the investors are not contemplating any move by the Fed through most of 2007. Just a month ago, traders were debating whether the Fed would cut rates in March or May. As of late Tuesday, the fed funds futures market prices in less than 50% odds of a single rate cut by the end of the year, according to Miller Tabak. Even minor odds of a rate hike -- 4% in May -- have crept into the market to really confuse things. RBC Capital Market's chief fixed-income strategist T.J. Marta says the Treasury market may have a "sell the rumor, buy the news" reaction to the Fed's statement Wednesday. Last week, Treasury yields rose sharply as traders removed the "oh my God, we're doing down view" from the table, he says. Rumors of a report in the market claiming inside information about a more hawkish FOMC statement means the market has already priced in the more aggressive statement, he adds. Ahead of the Fed's statement, Treasury bonds initially sold off, but then rallied on a weaker than expected Chicago PMI report for January at 10:00 a.m. EST. A read on manufacturing activity in the region, the report came in at 48.8, the lowest since April 2003. Likewise, construction spending fell 0.4% in the month, lower than consensus expectations for a flat reading.
Indeed, the Fed is still likely to reference worries about housing and possibly manufacturing to justify its pause, and the fourth-quarter GDP report and some regional manufacturing reports gives them ample evidence. Fears of what higher interest rates and adjustable-rate mortgage resets might do to the overall economy are still good enough reason for the Fed to tolerate a strong economy and slightly higher inflation. "The Fed is on hold for the year," says James Bianco, president of Bianco Research. But, "the Fed has to stay vigilant," says Darda, noting that the consumer has remained strong. "Their biggest fear was that housing would have a spillover effect to the consumer. Not only has that not happened, but the consumer is accelerating," he notes. "The idea that they would ease into this environment is ridiculous." The minutes from the Dec. 12 Fed meeting acknowledged that "there were some indications that home sales might be starting to stabilize," and that "the adjustment of activity and prices in the housing market did not appear to have spilled over significantly to consumer spending." Also, the only thing Bernanke said about the economy when he testified before the Senate Budget Committee earlier this month was that manufacturing is not hollowing out, particularly given the most recent industrial production data.
While regional manufacturing surveys may reveal that the Fed's tightening cycle has had its impact, the real test of the tightening is in the labor market, which has shown no signs of weakening thus far. Without rising unemployment, the Fed is unlikely to consider rate cuts. Indeed, Fed officials of late have repeatedly mentioned the heightened threat of wage inflation, with unemployment at 4.50% and showing no signs of slipping. As San Francisco Fed President Janet Yellen says, the labor market is "gangbusters." Stay tuned.