Is the Fed’s latest revision of its economic model pointing to a December increase in interest rates?
The decision on when the Federal Reserve will start to raise interest rates may rest with something called the output gap. And the most recent revision of an economic model at the Fed points to a December increase in rates because the output gap in the U.S. economy is projected to close in early 2016.
The Fed has released an updated version of the model of the U.S. economy put together by its staff. One key point in the model is a calculation of the speed limit for the U.S. economy. The speed limit is a projection of how fast the U.S. economy can grow before it uses up all the slack in the U.S. economy and starts to create inflation.
The newest revision puts the point where the economy will have used up that slack in the first quarter of 2016. After that quarter any increase in the speed of growth would create scarcity in such resources as workers and raw materials. What economists call the output gap—the difference between what the economy is producing and what it could produce without causing inflation—would have closed.
The newest revision of the Fed’s model of the economy estimates the economy’s speed limit at just 2% at an unemployment rate of 4.9%. The economy grew at a rate of 1.5% in the third quarter as companies reduced inventories. Real final sales, a measure of growth in the economy that excludes changes in inventories, grew at a 3% rate in the quarter. The official unemployment rate was 5.1% in September.
The approach to the point where faster growth would lead to inflation, according to the latest revision in Fed’s economic model, would certainly justify an increase in interest rates. Federal Reserve members have repeatedly noted that the time to raise interest rates is before inflation hits the Fed’s target of 2%.
If Federal Reserve policy is indeed “data-dependent” right now, this data point is signaling December.
What a week for potentially market-moving news!
Let me give you a quick run down, ok?
Monday: Beginning today and running through Thursday, the Central Committee of the Chinese Communist Party meets to formulate a new 5-year plan that would go into effect in 2016. Certainly on the agenda are a new target for economic growth, reforms for the country’s huge state-owned enterprises, and goals for continued urbanization, environmental regulation, and registration for China’s migrant workers. The goals aren’t actually released until ratified by the national legislature, which meets in March, and typically they don’t go into official effect until the fall. But while remaining officially unimplemented, many parts of China’s government start to react as soon as the meeting is over. That’s especially true of monetary authorities such as the People’s Bank. China’s central bank cut lending rates at the end of last week in anticipation of this meeting, but there’s still room for more moves on mortgage rates and restrictions, and bond issuance by local governments, just to name two issues. The Shanghai and Shenzhen markets were up modestly overnight (0.5% and 0.68%, respectively) in anticipation of the meeting.
Tuesday: Call it a preview of Thursday’s report on third quarter U.S. GDP growth. Wall Street is expecting a 1.3% drop in orders for durable goods for September. That would be an improvement from an even bigger decline in August. Look to see what the figures ex-aircraft show since a shift in the timing of one or 10 of these big-ticket orders can skew the entire top line of the report. Anything worse than Wall Street’s expectations will color opinion ahead of the GDP report.
Tuesday: It’s Apple (AAPL) day. The company reports revenue and earnings for its fiscal fourth quarter. Key issues will be sales of the new iPhone, where analysts will be looking for any signs of weakness in the launch, and sales in China, where they will be looking for signs that slowing growth in the Chinese economy has cut into sales. Apple CEO Tim Cook has repeatedly said that Apple isn’t seeing problems in its China results—that may have created expectations that could bite the company this quarter. I think Apple’s results this quarter are likely to have more effect on the market as a whole—where investors will look for clues to growth in the Chinese and global economies—than for technology stocks. Still watch for reaction from shares of Apple’s suppliers such as Analog Devices (ADI), Qualcomm (QCOM), and Synaptics (SYNA.)
Tuesday: More on strength or weakness in the U.S. economy when Ford Motor (F) reports third quarter earnings. (General Motors (GM) reported last week and showed a larger-than-expected gain in operating profits in North America.) Of particular interest at Ford will be sales for the company’s new mostly aluminum F-150 pickup truck.
Wednesday: The Federal Reserve’s Open Market Committee will probably do nothing on interest rates, but investors will be intently parsing any Fed comments for clues on what the U.S. central bank might do in December. Look for any change in the post-meeting statement on the Fed’s degree of worry about China now that it looks like that market has stabilized–for the moment, anyway.
Thursday: The U.S. Department of Commerce releases its preliminary estimate of third quarter GDP growth. Economists are looking for a year over year growth rate of just 1.9%, down from a 3.9% rate in the second quarter. The report will certainly move the odds on a December interest rate increase from the Federal Reserve. The odds for a December increase have moved up slightly recently on a decline in volatility in emerging markets.
Friday: The Bank of Japan meets: Will it stand pat on asset purchases and just reiterate recent comments from Governor Haruhiko Kuroda that the current program of quantitative easing is working (despite a lack of economic growth or inflation), or will the bank decide to increase its asset buying? Without some progress toward those two goals, the credibility of Abenomics will continue to erode. A promise last month from Prime Minister Shinzo Abe that the Japanese economy would be 20% larger by 2020 has resulted mostly in derisive laughter.
On revision second quarter U.S. GDP revised up to 3.7% from 2.3%–and U.S. stocks are off and running
Back on August 22 I posted that it looked like second quarter U.S. GDP growth would get revised upwards in a release scheduled for today, August 27. The initial estimate of 2.3% annualized growth could get revised upwards by as much as a full percentage point, I wrote.
Boy, was I wrong. Second quarter growth was revised upwards today to an 3.7% annualized rate, an increase of 1.4 percentage points from the prior estimate. None of the economists surveyed by Bloomberg forecast that big a revision. In addition, contracts to purchase previously owned homes climbed in July for the sixth time in the last seven months.
On the good news, U.S. stocks climbed with the Standard & Poor’s 500 up by 2.43 at the close and the Dow Jones Industrial Average ahead by 2.27%. (It didn’t hurt that China’s markets staged a big rally overnight, with the Shanghai Composite climbing 5.34%. That gave U.S. stocks plenty of upward momentum at the open.
So far, at least, I haven’t seen any comments suggesting that the higher than expected 3.7% growth rate might be strong enough to put a September interest rate increase back on the table. The consensus, which I don’t agree with, is that that ship has sailed.
One reason that I’m hearing today for thinking that this stronger than expected growth won’t lead the Fed to act in September is the fragility of the financial markets. Analysts raising that point aren’t gesturing at the Chinese equity markets but at the U.S. credit markets. The spread between the yields on high-yield bonds and Treasuries has expanded to 600 basis points (or 6 percentage points) as investors ramp up their anxiety about rising defaults, especially in the energy sector. Even taking out energy high yield bonds, also known as junk bonds, the spread to Treasuries is 100 basis points higher than a year ago. Does the Federal Reserve want to raise interest rates, they ask, when the debt markets are looking so shaky—at least in the high yield sector?
Volatility, which had spiked hard earlier in the weak, continued to fall with the Chicago Board Options Exchange Volatility Index, the VIX, declining today by another 9.2% to 27.52 after a 14% drop the day before. That’s quite a reversal from the charge in volatility that saw the VIX climb to its highest level since October 2011.
What is now a two-day rally in U.S. stocks put the S&P 500 on a path to its strongest back-to-back advance of the six-year bull market.
I usually start these brief recaps of stuff I’ve posted on my paid site with the phrase “What I’m thinking about today besides…” But today I’m not really thinking about anything but the rout in global stocks.
So it’s more appropriate to slug this post with a head that begins “Other takes” on today’s market, besides the general market view that I’ve posted here today.
In my regular Saturday Night Quarterback look at the week ahead I noted that normally we’d expect a bounce on a Monday after a two-day rout like that which ended last week. A bounce wouldn’t signal that the coast was clear, but the lack of a bounce would tell us that traders and investors were so fearful that they weren’t the slightest bit interested in bargain hunting and that we had a way to go before we could think about a bottom. I think today’s reaction in global markets and even the U.S. indicates deep, deep fear.
You’ll find evidence for that view in the extraordinary performance of the VIX volatility index, sometimes called the fear index. The index closed Friday at 28.03 and then soared to an intraday high of 53.29–indicating a huge increase in fear since the index tracks the price that traders and investors are willing to pay for options providing protection against a drop in the S&P 500. The VIX closed at 40.74 today for an extraordinary move of 45.34%. On the JubakAM.com site I recommended closing the trade in VIX options that I’d suggested on July 21. VIX options purchased that day for 83 cents closed today at $6.60. I’m no options trader but I’ve been following the VIX closely this year. On July 21 the VIX closed at 12.69, an extremely low level of volatility. I didn’t think the VIX would stay so low with the Federal Reserve set to meet on interest rates on September 17. I certainly didn’t predict that the Chinese stock market would tank global stocks.
And also on JubakAM.com I noted that I thought this correction/bear/whatever had moved into a new stage where instead of just taking profits in momentum stocks that had climbed the most in 2015, traders and investors had started to sell on liquidity. Selling a stock like say Netflix (NFLX) that would be easy to sell because it traded in volume makes sense at this stage because it will also be easy to buy it back when the coast is clear. I suggested three other stocks in the technology sector that on the basis of today’s action seemed to be part of a liquidity trade. In passing I also noted Apple CEO Tim Cook’s extraordinary email to CNBC’s Jim Cramer telling Cramer that iPhone sales in China had picked up in recent weeks. That kind of email to someone who co-manages a portfolio would seem to be at best on the shaky edge of security rules–and testifies to Apple’s worry about iPhone sales in China this quarter..
Just thought I’d let you know what I’m working on at JubakAM.com–I think there’s some value to you in passing on the direction of my thinking about this market on that site. Hope so anyway.
And, of course, there’s an ulterior motive: If you decide that you’d like more detail on those posts, I’m hoping that you’ll subscribe to my site at JubakAM.com for $199 a year. (By the way, you can get a full refund during the first seven days if you change your mind for any reason.)
Today, August 24, has been like two days (maybe three) in one. (Yesterday in my Saturday Night Quarterback post on my paid JubakAM.com site I told readers to watch to see if Monday brought a bounce or a continued decline. Well… how about both?)
First, there was the continued global rout that began in Asia—with the Shanghai Composite index closing down 8.49% and even the Japanese Nikkei 225 index participating in the downturn with a loss of 4.6%.
U.S. stocks opened hugely lower with the Dow Jones Industrial Average plunging 1000 points at the open for a 6.6% loss and the Standard & Poor’s 500 tumbling to a 5.3% decline. But then U.S. stocks rallied into midday and held on to much of those gains so that at 2:30 p.m. New York time the Dow was “only” off by 363.5 points (2.21%) and the Standard & Poor’s was down “only 2.64%.
And then, as U.S.markets moved toward the close, U.S. stocks fell again with the Dow Jones Industrial Average down 3.57% at the close and the S&P 500 falling by 3.94%. The swing in the NASDAQ was even wilder with a 6.6% loss “rallying” to a 2.16% loss by 2:30 p.m and then falling to a 3.82% loss as of the close.
There is actually some logic to the day’s action. The big worry is slowing global growth with the epicenter for that potential financial earthquake in China’s economy. So it’s “logical” that Shanghai would take the worst of the hit and that economies that export a lot to China would fall in concert. Europe’s biggest export economy, Germany, saw its DAX stock index down 4.7% at the close.
On the other hand, once traders and investors had a chance to get over their early shock at yet another big down day in Shanghai, it was “logical” for U.S. stocks to take back much of their early losses. The U.S. economy looks to be growing at a better than expected—if still modest rate—in the second and third quarters and with its huge domestic market, the U.S. economy has proportionately less exposure to global export growth or decline. Certainly a 2.2% loss in the Dow Industrial Average is nothing to cheer about, but it is nonetheless a comparatively better performance.
Volatility on the S&P 500 as measured by the CBOE volatility index, the VIX, soared in the morning to 53.29 as of 9:55 a.m. from a prior close at 28.03 before moving up again to 35.13 as of 2:30. That’s still a 43% pop in what is known as the fear index but that’s still a lot better than the 90% jump in the index at its high. (A higher index number indicates that options on the S&P 500 have moved up in price as more traders and investors decide to buy in order to hedge against market volatility.)
The rally within a down day didn’t stem the commodity markets from turning in another dismal performance. U.S. benchmark West Texas Intermediate crude, which breached the psychologically important $40 a barrel price intraday on Friday fell another 3.73% as of 2:30 p.m. New York time to $38.94 a barrel. Brent benchmark crude fell 4.18% to $43.56 a barrel. That move and the continued closing of the price gap between the U.S and the Brent global benchmark also has its logic if the U.S. economy will turn in relatively better growth than the global economy.
The Bloomberg Commodity Index fell to its lowest level since August 1999. Copper prices, a key indicator of expectations for global growth, fell 4% to the lowest level since 2009 on the London Metal Exchange.