U.S. stocks spent most of the session in negative territory as traders waited for the Fed, and they didn’t disappoint as Bernanke & Co. announced they’ll purchase another $600 billion in Treasury securities – in addition to the roughly $250 billion via reinvesting principal pay downs from the mortgage securities that currently reside on their balance sheet.  At which point, stocks rallied to positive territory.  More easy-money injections to financial institutions along with floored interest rates will push traders and investors into riskier assets…until it doesn’t.

The FOMC (the committee that makes these policy decisions) admitted that QE1 was a disappointed in terms of meeting their objective. So do more; that makes sense. 

In their defense, without efficacious help from fiscal policy the Fed’s the only game in town and this is all they have left in the arsenal – unless they pull a Bank of Japan and outright purchase stocks, corporate bonds, etc. But Bernanke prefers indirect market manipulation, so that’s unlikely – although his Op/Ed in this morning’s Washington Post explicitly admits that he’s targeting stock prices; so what’s the difference?  The fact that they’re traveling further down this unprecedented policy path illustrates the straits the economy is in.

Financials, telecoms and consumer discretionary shares led the rally.  Strangely, basic materials fell – one would think the commodity-related trade to roll on the QE announcement, but the group has outperformed in anticipation of further easing so probably just a little profit taking.  Commodities themselves rose a bit, as measured by the CRB, and if the early-morning trade in oil and metals is any indication they’ll extend the rally. 

The day’s economic releases were a net positive as the latest service-sector gauge improved for October, although the internals of the survey were mixed with the prices paid component jumping.  Also, the latest employment survey from outsourcing firm ADP came in better-than-expected.

Domestic vehicle sales also came in at a better-than-expected 12.25 million units at a seasonally adjusted annual rate, although it was pumped up by fleet sales as consumer buying was down.  

Market Activity for November 3, 2010

Mortgage Apps

The Mortgage Bankers Association reported that mortgage applications fell 5.0% in the week ended October 29 after rising 3.2% in the prior week.  The MBA’s index that tracks applications activity was dragged down by a 6.4% decline in refinancing apps, which currently account for 81% of the index. 

The average contract interest rate on the 30-year fixed mortgage rose to 4.28% last week, up from 4.25% in the week prior – the low of 4.21% was hit a month back.   Clearly, we’ll need a rate that closes in on 4.00% to fire up refi activity again.  However, as we’ve stated before, it’s pretty much the same people who keep refinancing as much of the market has been shut out due to a lack of equity in the home.

Purchases rose 1.4%, which follows a 3.9% increase in the week prior.  Nice to see positive number, but hardly sufficient to absorb the coming supply; absent substantial and durable job growth, the housing market will fail to repair.

ADP Employment

The employment change survey from payroll outsourcing firm Automatic Data Processing estimated that 43,000 private-sector jobs (expected to show a 20k increase) were added in October, which follows their estimate that 2,000 positions were eliminated in September – a reading that was revised up big from the initial -39k reported last month.

Goods-producing sectors cut payrolls by 34,000 as manufacturers eliminated 12,000 positions and construction slashed 23,000 (down 2.313 million since peaking in 2007).

Service-providing sectors increased payrolls by 77,000 in October (the ninth month of increase).  Of course, we are about to enter the holiday-shopping season so retailers will be adding more staff.  This is usually smoothed out in the seasonal adjustments, but that factor was distorted by last year’s massive job losses. 

Large firms (> 500 employees) cut payrolls by 2,000; medium-sized firms slashed 24,000 positions; small firm (> 50 employees) added 21,000 jobs. 

Ultimately we need Washington to announce that current tax rates will be extended and the health-care mandates repealed – these are killing small business job creation.  Yes, weak sales are not helping the matter, but we hardly need additional millstones around the necks of job creators – firms don’t even know what their marginal tax rates will be, which also hurts business spending at it’s difficult to estimate an after-tax return on investment.  

It’s always difficult to surmise what this ADP figure means for the official monthly payroll results, which we receive tomorrow.  I think a number of +43k on ADP corresponds with a 100K increase in the government’s private-sector results.  If so, this would beat the current estimate for an increase of 80k (government job cuts are expected to reduce the overall reading by about 20k).  These are levels insufficient to bring the jobless rate lower, but we’ll take triple-digit results. 

ISM Service

The Institute for Supply Management’s gauge of service-sector activity improved to a reading of 54.3 for October from 53.2 in September – beating the expectation of 53.5 and right in line with the measure’s historic average.  A reading above 50 marks expansion. 

The internals of the report were mixed.  New orders and export orders remained at a nice levels and the backlog of orders improved after falling to a contractionary reading of 48.0 in the previous month.

However, the inventory figure remained in contraction mode and the inventory sentiment reading jumped above 60 – a higher reading means that respondents are less comfortable with the level of stockpiles.  The employment reading inched up and is in line with the historic average but a weak level just ahead of the holiday shopping season. 

And the prices paid gauge surged to 68.3; the highest post-crisis reading we’ve seen yet and well above the historic average of 59.2.  (So, we get another indication that profit margins are going to get squeezed unless firms find an ability to raise prices.  This is not good for job growth as businesses will seek to keep other costs contained.)

Bottom line: this is a good headline reading, but some of the internals continue to suggest weakness in the months ahead.  Remember, this is a service-sector reading, so it will be helped as we enter the holiday shopping season.  It’s into 2011 when the weakness may arise. 

The ISM readings continue to diverge from the GDP readings.  What we’ve seen from both factory and service ISMs normally correspond with 5% GDP.  Instead we’re stuck at 2%, which is a function of weak final demand.   And despite what everyone says about overseas growth, the weak demand is a global issue too.  You see it in our exports, which have cooled rather significantly. 

FOMC Statement…and Action

In the statement following the FOMC meeting, the Committee stated that the pace of recovery in output and employment continues to slow; household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower household wealth, and tight credit; business spending has slowed; employers remain reluctant to hire; housing starts are depressed; and inflation has trended lower in recent quarters. 

As a result, enter QE2.  The specifics are $600 billion of longer-term Treasury purchases by June 2011 – in addition to $250-$300 billion in Treasury purchases from reinvesting proceeds from principal pay downs via their current holdings of mortgage-backed securities.  The Fed will concentrate on the middle of the curve as the average duration of these purchases will be 5-6 years.  (This is the only part of the policy that surprised the market, which thought more buying would be done at the long-end – the 30-yr Treasury sold off, which means the yield rose.) Of course, they’ll also hold the target rate on fed funds at virtual zero. 

The FOMC statement also mentioned that progress towards the Fed’s objectives have been “disappointingly slow.”  While they may still be able to push people into riskier assets (stocks, corporate bonds, REITS, etc.) they will continue to be disappointed because this policy will do nothing to kick start job growth.   Encouraging the job growth we need will take actions from the fiscal side of policy and that means keeping tax rates low (or even enhancements the current tax code – I know that’s fantasy, but I’m just sayin’), the elimination of regulatory and health-care mandate roadblocks, and serious curtailment on the spending side of the budget. 

So long as we get no help from this end of public policy, Bernanke will feel like he must do all that he can to ignite a substantial recovery, and that means we’ll have to once again deal with the consequences of these decisions in the future. 

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Have a great day!

Brent Vondera, Senior Analyst