The Fed's decision to start raising rates created some serious confusion in the markets. Is it really a game changer?
The Fed's late Thursday evening announcement they were raising the discount rate to .75% from .50% caused some severe reactions in the currency and futures markets. The S&P futures dropped -12 points Thursday night and knocked the markets for a loss at Friday's open. The Dollar shot up to new highs and the Euro and pound both crashed.
The equity markets recovered quickly after the economic reports hit the wires. The headline number on the Consumer Price Index for January increased by +0.2%. Seasonally adjusted the 12-month inflation rate is now +2.7%. The core rate actually fell by -0.1% in January and the 12 month core rate is only 1.5%.
Food prices have declined for the last five months while energy has risen sharply since October with a +2.8% gain in January. The drop in the core CPI by -0.1% was the first time the core rate has fallen since 1982. There is still ample evidence that the deflation risk has not gone away. Consumer demand is so weak that retailers have no pricing power. It is a battle to retain market share in a declining economy and the only way to do that is with lower prices.
Rents fell as did airline fares and the service CPI would have been much lower were it not for a spike in medical care rates. If it were not for the rise in energy prices at all levels we would be seeing deflationary numbers in the CPI. That is a double-edged sword. As energy prices rise, primarily gasoline and diesel prices, the amount of available cash left for consumers to spend on other items will decline. This makes it even harder for the U.S. to pull out of the recession. The 25 million unemployed workers also have a shortage of cash for discretionary purchases. This lack of spending power is preventing inflation from rising and should keep the Fed on the sidelines for several more months.
Consumer Price Index Chart
Another bullish economic report was the mortgage delinquency rate for Q4. Mortgage delinquencies fell for the first time in nearly three years, falling by 17 basis points to 9.47% in Q4. That is still +159 basis point higher than Q4-2008 and 340 points above the peak in the early 1980s housing recession.
Delinquencies on prime adjustable rate mortgages fell by 27 basis points to 12.1% and subprime adjustable rate delinquencies fell by 154 points to 26.69%. Those are still horrendous numbers by any measure but still a step in the right direction.
The number of prime mortgages entering foreclosure fell to 0.86% with new subprime foreclosures falling from 3.76% to 3.66% of all loans. With job losses slowing, the rate of new delinquencies should continue to decline. Unfortunately lots of those delinquent loans are still going to foreclosure. The percentage of loans 90-days delinquent rose in Q4 as banks tried to modify more loans rather than post them for foreclosure. Also, as I have reported before, banks will delay taking foreclosure action during the winter in order to leave people in the homes with the heat on rather than have a vacant house with frozen pipes. This causes thousand of dollars in damage when they thaw out and flood the houses.
Mortgage Delinquency Rate Chart
The big news of course was the Fed's decision to raise the discount rate to .75% from .50% and announce it after the market closed on Thursday. The timing was interesting since they could have done it at any time but chose to announce it after a market close rather than before the open or at the FOMC meeting where they normally announce these changes.
Analysts should have expected a move from the Fed because Bernanke said it was coming in his testimony last week. He did not exactly spell it out but said changes were coming "soon." Apparently analysts thought soon meant over several months instead of now.
Friday's volatility was way over done because the change only impacts those banks that are using the Fed's discount window for emergency overnight loans. Those types of loans peaked at $110 billion a day during the financial crisis and have fallen to an average of $14 billion today. Banks that have to borrow at the discount window have much bigger problems than the quarter point hike.
The Fed was clear in their announcement that nothing else had changed. "The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy, which remains about as it was at the January meeting of the Federal Open Market Committee (FOMC). At that meeting, the Committee left its target range for the federal funds rate at 0 to 1/4 percent and said it anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period." Clearly the Fed reemphasized the "extended period" clause.
Atlanta Federal Reserve president Dennis Lockhart reiterated that position. "I would not interpret this action as a tightening of monetary policy or even a sign that a tightening is imminent," Lockhart said in a speech. "Rather, this action should be viewed as a normalization step."
New York Fed President, William Dudley, said the Fed's pledge to keep benchmark rates low for an extended period of time "is still very much in place." He said the change in the discount rate was a technical change only and did not carry any significance regarding the U.S. monetary policy.
The problem with the discount hike is simply that it is the first step in a very long journey. As long as the Fed was sitting quietly on the sidelines with their "extended period" language they were not a threat to anyone. The discount rate hike was the first sign of the coming changes. It was like the first raindrop or first crack of thunder on a summer day. Neither is an immediate problem but they signal an approaching storm and time to start thinking about taking cover. The Fed funds futures are only pricing in the potential for a quarter point hike in November so definitely no worry about a surprise rate hike.
Former Fed governor Lyle Gramley said he expected the discount rate to be hiked again before the first Fed rate hike, which he does not expect until early 2011. Mohamed el-Erian, Pimco co-CEO, also said they don't expect a rate hike until 2011. Bill Gross said the discount rate hike was the Fed's version of Groundhog Day. The Fed saw its shadow and raised the discount rate. Now there will be six more months of zero-degree interest rates before they act again.
A couple Morgan Stanley analysts said their concerns were for a policy induced double dip. The recovery in the late 1930s and in Japan in the 1990s were both killed by regulators trying to remove the stimulus too quickly and raise taxes to pay for the stimulus.
Since Bernanke is a student of the great depression I seriously doubt he is going to make that mistake but the Fed in general has a really bad track record for removing stimulus. They almost always act too soon or remove the stimulus too quickly and it stunts the recovery progress. With 25 million people out of work we can't afford for the Fed to make a mistake this time around.
Commercial banks are currently sitting on $1.3 trillion in cash because they are worried about a second dip and they are worried about the growing commercial real estate loan problem. The extend and pretend scenario for commercial real estate loans has just about run its course and 50% of properties are now underwater. By stockpiling cash these banks protect themselves against future loan defaults and it puts them into a position to acquire other banks that were not so prudent. The FDIC said there could be as many as 1,000 banks closed over the next two years and healthy banks are hoarding cash so they can make a bid when the FDIC calls with an offer. The easiest way for a bank to grow is by taking over the assets and customers of a failed bank in an FDIC auction.
The FDIC announced the closing of four more banks on Friday bringing the total for 2010 to 20 banks. La Jolla Bank in San Diego, George Washington Savings Bank of Oakland Park Illinois, La Coste National Bank of La Coste Texas and Marco Community Bank of Marco Island Florida were all closed. La Jolla was the largest with $3.6 billion in total assets. All four banks were sold to other banks so there is a good reason to keep cash on hand.
I am not worried about the discount rate increase. I am more interested in the potential for a sovereign debt default or a failed bond auction. Next week the U.S. is going to auction roughly $185 billion in debt. That is 75% of the $245 billion total debt owed by Greece. We are basically selling the equivalent debt of a small country every other week. You may remember last week I wrote that the number of bidders was shrinking and with the billions being offered each month we are eventually going to run out of bidders. This is what I worry about and it would be a death knell to the stock market if it occurs.
As long as the inflation rate and the non-farm payrolls remain flat the Fed is not going to raise rates. Of course we have the artificial improvement to jobs of more than one million over the next three months for census hires. Surely the Fed is smart enough to see the bump in jobs is only temporary and not do something stupid.
Next week we will get another look into Bernanke's head when he testifies to the House Financial Services committee on Wednesday and the Senate Banking committee on Thursday. This is his semi annual testimony and you can bet the interrogators will be ready with plenty of pointed questions. He also speaks on Monday on the need for more stimulus.
The SEC announced it would consider new regulations on short selling when it meets next week. Some traders had been pressing the SEC to reinstate the uptick rule, which dated back to the depression. The uptick rule would only allow a short sale at a higher price than the last sale. There had to be an up-tick in price before the sale was allowed. In theory this prevented thousands of sellers from placing sell orders at the same time and flushing a stock without a chance for reprieve. That uptick may have slowed declines in the fractional market when trades moved in eights or quarters and traded through a market maker but in today's electronic penny market it had little impact. The SEC abolished the rule in 2007 saying it was useless in today's modern markets.
Some proposals being considered include a circuit breaker that would trigger a "passive bid test" which would only allow short selling above a national best bid. They are also considering a circuit breaker that would kick in if a stock's price fell by more than a certain percent such as 10 percent.
Shares of Dell Computer (DELL) fell nearly -7% on Friday after posting earnings that were better than expected and a revenue surprise of roughly $1 billion more than estimates. The problem was a continued drop in profit margins to 17.4% from 18.2% in the comparison quarter. Dell said margins were hurt by a larger mix of low cost PCs and some higher component costs. This compares to the 22% margins reported by Hewlett Packard. Analysts were surprised the extra $1 billion in revenue did not help puff up the margins. Dell is now the number three computer maker after being passed by Acer.
First Solar (FSLR) lost $10.29 after it warned that profits in the second half of 2010 could be clouded by reductions in European subsidies. FSLR posted earnings of $1.65 and beat estimates of $1.52 but was crushed by the uncertainty. Solar stocks in general have had a rough road lately as governments hurt by the recession are cutting the tax credits and subsidies for installing alternative energy products. Germany is the largest solar market and they have proposed a 15% reduction in subsidies and may cut credits even further. FSLR is known for giving cautious guidance so this may be a bit of "under promise" in action.
First Solar Chart
Honeywell (HON) rallied on Friday with a fourth day of gains. Friday's rally was due to upgraded guidance from the company. Honeywell raised its guidance to 40-45 cents from 35-40 cents. The gains capped off a nice week for the manufacturer.
Intuit (INTU) rallied nearly 8% after it posted strong earnings of 35-cents and raised guidance. This compares to earnings of 26-cents in the year ago quarter. Revenue was up +15%. Seems the advertisement by Tim Geithner must have helped send buyers into stores looking for Turbo Tax software. If it is good enough for the Treasury Secretary it must be good enough for consumers.
Juniper (JNPR) rallied +6% on Friday on no news. Call volume for the week was roughly three times normal and Friday's spike was way out of character. Since there was no news it suggests there may be a takeover offer in the works and the news leaked to a privileged few. Several companies have always been rumored to be interested in Juniper but the rumors never come true. They build great gear but are continually overshadowed by Cisco. If you know why Juniper exploded on Friday let me know.
The currency markets made once a year moves after the Fed announcement. The dollar soared to resistance at 81 on the dollar index before profit taking pushed it lower. The Euro fell to a new nine month low at 134.57 and the outlook is not good. The EU is under pressure and every day brings another analyst out into the light of day to proclaim the eventual breakup of the EU.
Chart of the Euro
Chart of the dollar index
The British Pound is going into free fall on worries that the Bank of England will have to enact further quantitive easing in order to keep the economy from falling back into a deeper recession. BOE board member, Kate Barker, gave a cautious statement during an interview saying she expects the recovery to be quite hesitant this year and at risk for another quarter of negative growth. A separate report from the BOE showed mortgage approvals fell to 49,000 in January from 60,000 in December. Government borrowing increased 4.3 billion GBP in January to mark the first budget deficit since 1993.
Pound Sterling Chart
On the positive side market sentiment appears to be improving. Insider selling has slowed and the pace of insider buying has increased. Since insiders theoretically have knowledge that investors don't have it pays to watch the pace of buying and selling as a market indicator. Insiders have to report to the SEC when they buy or sell shares so that gives investors a window into the current trends.
Argus Research reported that insider selling for the week of January 15th, the market top, reached 5.15-to-1. That means 5.15 shares were sold for every share bought by insiders. For the week of February 12th that ratio decreased to 2.42-to-1 and a decline by more than half. That may still sound negative but in the new normal employees have been getting much more of their compensation in stock and that means they have to sell to the stock to pay bills. Jonathan Moreland, another insider trading tracker, said he has been convinced to buy the dip. Orbitz (OWW) was one company with large insider buying.
Greece has not gone away. In fact they may be back even bigger than ever next week. Greece announced this week they are going to try and sell â‚¬5 billion ($6.8B) in 10-year bonds next week. No date has been set. They are going to test the markets with a token debt offering and the results of that sale could be catastrophic. If the sale is successful the pressure on the EU and the Euro would diminish.
If the sale fails the EU leaders would have to decide ASAP on how they were going to construct a bailout. Without an immediate bailout Greece would default on roughly â‚¬28 billion in debt redemptions due by April. Greece has already been given a deadline of March 16th to prove it is serious about cutting costs.
The bond sale is as much a referendum on the EU as it is on Greece. The confusion in the EU in recent weeks has weakened the stature of the EU and the Euro.
In the January auction Greece sold â‚¬8 billion in five-year bonds. With 600+ bidders the auction was originally called a success but within two days the value of the bonds fell -3.5%. That is an unheard of drop in government securities. Credit default swaps on Greek debt are now at record highs. If Greece follows through with this sale and it fails it will have big repercussions on the financial markets.
The economic calendar is littered with potholes next week. Bernanke speaks three times and Monday's speech is "Do we need more stimulus?" That should be a guarantee of volatility. There is also $180 billion in debt auctions and that should scare everyone.
Bernanke will speak again on Wednesday and Thursday in his twice a year testimony to the House and Senate. After Monday's speech I doubt we will get a different version later in the week but lawmakers will be asking the questions.
On Thursday the president's televised show at the White House over health care reform is sure to be boring to watch and I am sure the networks will cover it even though we already know the outcome.
The GDP revision on Friday is expected to be revised higher on changes to the inventory numbers. This is not real growth but more voodoo economics at work. The Chicago ISM on Friday is expected to decline. These are the activity numbers for February and by all accounts the economy may not be slipping but it is definitely not growing.
To get to this point you have suffered through about 3,200 words. If I thought I could keep writing and not have to pick a market direction for next week I would keep on writing. Unfortunately it does not work that way and I have to pull a direction off the charts.
The indicators this week are so confusing it looks like they were put in a blender for five minutes on chop. Some indexes are stuck under resistance and some are in breakout mode. With the exception of Christmas the volume last week was the lowest in the last three months. We averaged only 7.4 billion shares per day and this was an option expiration week.
Internals were positive every day and all the indexes posted gains around +3%. Given the conflicting economics, conflicting earnings guidance, geopolitical problems and the Fed discount rate hike it was amazing we posted any gains. I guess that is what tipped the scales into the bullish column for me for next week. Lots of bad news was ignored and the markets moved higher.
The problem for next week is the lack of a breakout on a couple key indexes. The NYSE composite is a mixture of very large and very small stocks and everything in between. It is all the stocks on the NYSE. The index came to a dead stop on the 100-day average and is showing no indication of a pending breakout.
NYSE Composite Chart
The Dow transports came to a dead stop on resistance and is showing no indications of a breakout despite a week of strong gains. The transports should rally in advance of a recovery and assist in leading the Dow higher. This stop on resistance is troubling.
Dow Transports Chart
The Dow rallied over resistance at 10300 but came to rest right on uptrend resistance that was prior support. The 50-day average also came back into play. If the uptrend resistance at 10400 can be broken there is another battle at 10500. The Dow is fairly extended after four days of gains and may need to rest for a day or two. A move over 10500 should also break 10750 and move to a new high. A failure at 10500 could retest the lows.
The S&P-500 broke over 1100-1105 and promptly ran into the 50% Fib retracement level at 1116. This was serious resistance the last time it was tested in Nov/Dec and should remain resistance. If the S&P can move over this level the next resistance at 1150 should also break. A move over 1116 would be strongly bullish.
The Nasdaq moved over round number resistance at 2200 and pushed though the 50-day average. Now it is facing the Fib retracement level at 2250. The Nasdaq did not respect that resistance the first time through in December and I don't expect it to exert much pressure this time around. The next real resistance is 2320 and the January highs. If this is a real rally and techs are going to lead all the indexes higher then the Nasdaq must break over 2320 to a new high and do it on strong volume.
The Russell was in the top five strongest indexes again last week with a +3.42% gain. This is the second week that the Russell outperformed and it did so with the Transports, Semiconductors, Biotech, Energy and Banking. Those are the sectors you would want to see outperforming in a real rally. Those are the leadership sectors and they are all leading.
I pointed out this fact last Sunday and suggested a breakout was imminent. I still believe these indexes should be our guide in the coming week. As long as the Russell and its friends are in rally mode the rest of the market will eventually come along.
Russell 2000 Chart
The broadest index of them all is the Wilshire 5000 and it broke over uptrend resistance (dash) and resistance at 11400 to breakout on Friday. This index is not moved by individual stocks and represents a truer picture of the market than the Dow or S&P. It appears to be in breakout mode but we really need to see another day of gains to confirm.
Wilshire 5000 Chart
Despite the gains last week the markets moved up on very low volume. We have the equivalent of a stealth rally even though the Dow gained +300 points. Bears are obviously waiting for a pause point to initiate new positions and bulls are waiting for a clear sign to enter new positions. With both sides waiting for an entry point the path of least resistance is now up.
In a stealth rally those investors on the sidelines will eventually get tired of watching the markets move higher without them and start to abandon caution and dive in. This is when the markets should pickup speed as volume increases.
However, we still have some resistance to work through and probably some profit taking to endure. I am cautiously bullish because the Russell, Dow Transports and Semiconductors are leading the charge. Until proven wrong I think we need to follow the trend.
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