Early stock gains fizzled for a third-straight session, pushing the major indices into negative territory around midday and never regained momentum.  Bonds sold off again and higher interest rates appeared to be the largest drag on the equity market.  Continued concerns about Europe didn’t help. 

If may not prove evident just yet, I’m not convinced that the latest trend signals a secular bear market for bonds, but the Fed has the economy backed into a corner.  Even if rates are rising because near-term growth estimates have been increased (which would be the good kind of rate increase in a normal situation), then we still have this little problem of the housing market and an economy that has become conditioned to insanely low rates.  It’s not that rates have broken out of some longer-term range, the yield on the 10-year Treasury has merely backed up to a level seen in May, yet stocks appear uneasy with this move. 

The S&P 500 index that track consumer staple shares was the only of the top 10 industry groups to close higher yesterday.  Utility and telecom shares were the biggest losers – highest dividend yielding segments of the market get hit the most by higher interest rates.  Again, I don’t think this move in rates is durable – not yet.   There are still too many economic headwinds and the Fed will pull something else out of their hat to force rates lower again.  Eventually the market will overwhelm Fed action, but I just don’t believe we’re there yet. 

The CRB Index slipped a bit yesterday as the precious metals and another decline in OJ prices weighed on the index.  The prices of cocoa, sugar and energy commodities moved higher.

While the spot price of oil closed higher yesterday ($88.50/barrel), it backed off of the initial gains that followed the weekly energy report.  Crude inventories slid 9.85 million barrels to 346 million (still 6% above the five-year average) – forecast to fall just 2.5 million.  The plunge had some analysts calling for $100/barrel within the next two weeks. 

Maybe not quite so fast.  Energy analyst Steven Schork explained that the inventory decline was due to year-end dynamics, as Gulf Coast refineries minimized import orders as they manage inventories for tax purposes – they are taxed based on the amount of crude they hold at year end.  Also cutting into supplies was higher refining output as refiners’ margins have bounced.  We’ll keep a close eye on this story as $90-plus crude means $3-plus gasoline, and if that price remains sticky it will offset much of the income boost from next year’s payroll tax reduction. 

Market Activity for December 15, 2010

Mortgage Apps

The Mortgage Bankers Association’s applications index fell 2.3% for the week ended December 10 -- the third-straight decline as the average contract rate on 30-year fixed mortgage rose for a fifth-straight week, approaching 5% last week and surpassing it this week. 

Applications to refinance slipped 0.7% in the week ended December 10 – the fifth week of decline and perfectly corresponds to the rise in mortgage rates.  Applications to purchase a home fell 5.0% after three weeks of gain. 

Under normal conditions, the housing market could certainly withstand mortgages rates rising to 6 even 7%.  However, this housing market, with its major structural difficulties of high joblessness and a huge inventory overhang, probably cannot withstand a 5%-plus cost of money.  (The rate was at 5% in the spring and sales rose, but the market had the tax credit to fall back on; it’s on its on now.)

Consumer Price Index

The Labor Department reported that headline CPI rose 0.1% in November (expected to come in at 0.2%) and the core rate rose 0.1% (in line with expectations) for the first monthly increase in four months.   On a year-over-year basis headline is up just 1.1% and core (which excludes food and energy) is up just 0.8%.

As we’ve talked about for many months, the thing to watch is loan activity -- bank credit.  Until overall credit begins to expand again, inflation will not take off because the velocity of money is very low.  But there is imbedded inflation in the pipeline as industrial and agricultural commodities have jumped. When credit begins to expand again, we’ll see the official inflation gauges begin to rise to more harmful levels. 

The Fed continues to rely on core inflation, and conventional wisdom must eventually acknowledge that they look at this measure because it gives them cover to keep policy aggressively easy even as headline inflation begins to pick up.  It is completely inappropriate to use this gauge because food and energy are necessities that households cannot avoid and they eventually feed into other prices. 

We’ll continue to watch bank credit (both C&I and consumer credit), as this will be the canary.  Lending activity has bottomed, but has yet to meaningfully expand again. 

Empire Manufacturing

The NY Federal Reserve Bank’s gauge of factory activity within the second Federal Reserve district rebounded very nicely for December after plunging by the largest degree since the 9/11 attacks in November.  The reading bounced nearly 22 points to 10.57 for December from -11.14 in the previous month.  I don’t know what happened in November, the report didn’t offer any clues. 

Many of the measure’s internals (sub-indices) remained weak.  While new orders bounced back to expansion mode, rising to 2.60 from deep contraction of -24.38, inventories fell back to contraction, unfilled orders remained negative, and the number of employees and the average workweek both deteriorated – the former falling to contraction mode and the latter declining further, now negative for two-straight months.

The regional along with ISM (nationwide) factory measures continue to suggest that manufacturing activity remains solid, if not strong in general.  However, the past four months of payroll data has shown declines in factory employment and this may suggest some weakness has arisen.  I had expected the sector to show significant damage by now, but that’s not the case.  It all depends on the inventory cycle.  If demand picks up to a point that gives businesses the confidence to continue building stockpiles, then the manufacturing sector will hold up.  If not then it’s only a short matter of time in which factory activity wanes.

Industrial Production

The Federal Reserve reported that industrial production (IP) rose 0.4% in November, following a 0.2% decline in October that was revised down from the initial print of no change (0%).  That October reading was pushed lower by a large 3.7% decline in utility production as temps were warmer than usual.

Now we’re colder than normal and the utility production has bounced back – up 1.9% in November.  The segment accounted for half of the total IP gain even though it makes up just 12% of the total index.  Nevertheless, the manufacturing component, which accounts for 75% of the index, rose a nice 0.3% for the month.

Overall capacity utilization (CU), or the percentage of facilities that is being used, rose to 75.2% from 74.9% -- the long-term, average is 80%. 

The CU rates improved for two of the three IP components rose.  Manufacturing CU rose to 72.8% from 72.6% (80% is the long-term average); utility CU jumped to 78.4% from 76.9% (but well below the long-term average of 87.5%); mining CU slipped to 88.7% from 88.8% (although it remains above the long-term average of 87.2%).  

The overall CU rate is important because it’s a major gauge for the Fed.  Bernanke says he’ll begin to unwind policy when the rate returns to normal. We’ll see.  If unemployment remains very high, I doubt he’ll voluntarily take his foot off the monetary policy accelerator. 

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Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900