Fed Aggressively Cuts Rates

The Fed lowered interest rates today but farther than many (included myself) had expected. Recall, I had anticipated the combination of a 25 basis point fed funds rate cut and a 50 basis point discount rate cut. Along with this, I expected a statement that indicated further rate cuts would be forthcoming as needed.

Recall there are currently two problems facing us -- a slowing economy, which the fed funds rate impacts, and a liquidity/credit crunch crisis that the discount rate addresses. And, there is the question of how much the US economy will slow in upcoming months. Nobody knows this for sure (no matter what they pretend). And, the two "dangerous ingredients," the slowing economy and credit crisis might possibly combine and become very "explosive," meaning cause a more severe slowdown and/or recession. Apparently, it is this potentially explosive combination that the Fed reacted to. And, given the lags in monetary policy changes (6-9 months), the Fed HAD TO BE PROACTIVE. Remember, Ben Bernanke has not been the Fed Chair for very long, so he still has to establish his "Fed Cred," or credibility. And, all the press play for former Chair Greenspan's book probably influenced the magnitude of the move somewhat (this Fed can't allow itself to possibly be "behind the curve" of this slowdown.

The result TODAY: the stock market got what it hoped for, so there was a major increase, +335 points for the Dow Jones, a full +70 points for the NASDAQ, and +43 points for the S&P 500. Shorter duration interest rates fell, a very healthy sign (we will discuss this in the next week it has to do with the yield curve) for future growth prospects. And, the exchange rate picture was mixed: the US dollar rose against the Japanese Yen, but fell against both the Euro and British Pound.

The chart shows Cyclicals ($CYC) for the past three months (click to enlarge). Note how, over this period, the 50-day moving average was originally support (until late July), then became resistance. Today, after the Fed's rate change, there was a very large increase. Note how tall today's bar is and that the close was at the day's high. More importantly, today's close broke above the 50-day moving average. Also, look at the RSI(9) above the cyclicals. It has recently moved into the bullish range, above 50. Finally, the price relative, comparing cyclicals to the stock market (in terms of the S&P 500) has turned up recently. Part of today's large increase was the result of "short covering," where persons had sold shares of various stocks betting that their prices would decline. When the news came out, they hurried to buy back the stocks (covering their shorts). This added demand was an important contributor to today's large run up in prices.

What about tomorrow? Now that the markets got what they wanted, there will no doubt be further deliberation and possibly second guessing of the Fed's decision. Was the large rate cut a sign that the Fed thinks things are actually worse then they have led us to believe up until now? Will today's breakout be sustained, or will something else come to the forefront, making today a "one day wonder," or in technical terms, a failed breakout. Keep following cyclicals through the rest of this week into next week.

August Employment Report

The August employment report came in with a bang. While the consensus prediction for payroll employment was around +110,000 (I had figured around +50,000), the figure released by the Bureau of Labor Statistics was -4,000 -- the first month-to-month decline in four years. Ouch!! You can read about the report.

As I stated in class, this would clearly be one of those "other things are not equal" situations. On the one hand, a weak employment report further fuels the expectation that the Fed will lower rates at its next meeting on 9/18, possibly by 50 basis points (1/2 of a percentage point). That is a positive for the stock market (which is driven primarily by profit expectations and interest rates).
But, weak employment signals less spendable income in future months, which will cut into profits, a negative for stocks. Which effect would dominate? As the morning unfolded it became readily apparent that the negative aspects were more than offsetting the positive factors.

But how could this be? If the Fed will be lowering interest rates soon, and the unemployment remained unchanged, why so negative a reaction by the markets? That's where it is necessary to read the details of the report. First, let me state a rule for judging reports: NEVER PLACE TOO MUCH WEIGHT ON A SINGLE MONTH'S VALUE. Actually the markets didn't. As it turned out, the employment totals for the prior two months were revised sharply lower. This brings me to a second rule: ALWAYS LOOK AT REVISIONS TO PRIOR TIME PERIODS BEFORE JUDGING THE CURRENT VALUE. So, instead of having an average monthly employment gain of around 110,000 over the past three months, the average (with revisions) becomes only +44,000. In addition to this, a further examination of the unemployment rate is called for. While the unemployment rate remained unchanged at 4.6%, the labor force dropped sharply. Had the labor force participation rate (% of population in the labor force) remained the same as it was last month, August's unemployment would have surged to 5%. Now it should become more apparent why the negative reaction occurred.

It is important to keep in mind that the primary factor determining whether a recession is upcoming is whether housing weakness is "contained." The dominant view has been that as long as employment remains strong and the unemployment rate doesn't rise too much, persons should generally be able to afford their mortgages, limiting housing damage. Well, in August, employment fell and the unemployment rate should have risen (with the same participation rate as last month). So, it is not clear how much "containment" will exist going forward, raising the likelihood of a recession (my estimate this entire year has been 45%, well above the consensus until very recently). Add to this the fact that a very large number of mortgages will be "resetting" to higher interest rates in October, and you can see the basis for the stock market selloff. Here's an article highlighting whether a recession is likely.

While we haven't covered it yet, another big reaction to the weak employment report was a sharp drop in interest rates. The 10-year government bond, which is linked to mortgage rates, fell from 4.50% to 4.37%, a 13 basis point drop in one day!! Bonds are fixed (nominal) income assets, meaning they pay fixed amounts of income per year. "Bad news" about the economy, like this employment report, is good news to the bond market as it implies less of an inflation threat in the future (inflation lowers nominal income). And, we will see (later this coming week) that bond prices and interest rates move in opposite directions. So, on Friday we had a stock market sell off and a bond market rally!! Finally, not unrelated to all of this was a sharp rise in gold prices. See if you can figure out gold prices rose. (Hint: it is related to interest rate changes.)

All of this should demonstrate the point I made the first day of class: if you understand macroeconomics you tend to think in terms of sequences (sets) of variable changes, not just what is happening to a single variable. The ability to do this takes practice. Judging by the way this semester has started, you'll be getting lots of practice!

Inflationary Expectations are Rising

Recently the Fed affirmed its worries about rising inflation. If you want to read a good article about this, click here. And today the Producer Price Index (PPI) report for March was released (click for article). How can we examine inflationary expectations without waiting until a CPI, PPI, or GDP deflator report is released? The answer is to examine the ratio of TIP prices (Treasury Inflation-Protected Securities) to nominal bond prices. I have found it useful to use the ratio of 20+ year bonds. In StockCharts.com, the symbols for these are TIP and TLT. So, to examine the ratio, use TIP:TLT. Also, switch to viewing this as a line graph and remove moving averages, etc. but keep the RSI (use 9 periods). The resulting chart is given below (click on the image to enlarge it).

A critical technical formation has appeared with this ratio: a double bottom. Recall from Stikki Stock Charts that a double bottom is a reversal pattern. This price ratio has failed to break below a support level twice, which often (BUT NOT ALWAYS) signals an upward move is forthcoming. According to technical analysis, it is possible to determine a likely upside price target assuming a reversal does occur. To do this, form a neckline connecting prior recent peaks (i.e., resistance). In the present example this is at 1.148. Subtract from this the value of the bottom, which is 1.121, which I will round to 1.12. Then add this difference to the neckline value to arrive at the price target:

TARGET Change = Neckline - Bottom
= 1.148 - 1.12 = 0.028
TARGET VALUE = Neckline + Target Change
= 1.148 + 0.028 = 1.176

So, should this double bottom play out as a reversal, we would expect to see the ration TIP:TLT rise to around 1.176. The graph contains this information with a horizontal line drawn at this value. Notice anything interesting? The price target move us almost exactly to a prior level of support from June of 2006!

How likely is it that we will actually reach 1.176? Note from the RSI that it is not yet overbought, so there is room to move up. It is not far from the overbought reading of 70, however, so there will likely be a short-term downward move before that target would actually be reached. I suggest that you consider a support for the upside rally of a value of 50 for the RSI. As long as the RSI(9) remains at or above 50, don't rule out the possibility of reaching the upside target.

Employment Report -- March

Yesterday the March employment report was released. To the surprise of many (including me), payroll employment rose by 180,000 over the February total. This was far above the consensus estimate of around 130,000. Ironically, there was no effect whatsoever upon the stock market. Of course, that's because the markets were closed the day the report was released. So, Monday should start off with a bang, as traders have had the entire weekend to think about their reaction to the report.

Part of the reason for a larger-than-expected employment gain was that when the February survey was undertaken there was a snow storm, which prevented some persons from getting to work during that week. THE EMPLOYMENT SURVEY IS CONDUCTED DURING THE WEEK THAT INCLUDES THE 12TH OF EACH MONTH. So, comparing to a month with snow storms leads to some distortions. February likely understated employment, and March, comparing to February, overstated employment strength. While the employment data are seasonally adjusted (a statistical smoothing that takes into account events that happen "normally" at the same point each year), atypical events -- like February's snow storm, often cause seasonal adjustment distortions. A very readable article describing seasonal adjustment in on the online syllabus. Access it here.

So, while we have to wait until Monday to see how the employment report will affect the stock and bond markets, there was a great deal of discussion about the report overall and its likely asset market effects on television Friday. One question that is emerging about "good news" is whether the stock market will react positively or negatively at the present time. Why? Because "good news" may signal the increased likelihood of Fed tightening. And, we saw earlier in the semester, that rising interest rates are bad for stock prices (often referred to as a "head wind"). But, a stronger economy means profit strength in the future, which is a plus for stock prices. So, which effect will predominate with investors? Stay tuned, we'll see. Here's a Friday article that discusses this. Let's see how accurate it proves to be.

Along with employment, the monthly labor market report also has information on the unemployment rate, which fell unexpectedly from 4.6% to 4.4%, placing us at full employment, an average hourly wage growth. Often this is taken to be an inflation indicator, but it really isn't that good at signaling future inflation (here's an article discussing that). Actual wage growth was 0.3%, the expected amount, so there is not likely to be any reaction to that aspect of the report. As I stated in class, there are composition effects to wage change, determined by the types of jobs that are added in a given month. If lots of "high wage" jobs are added, the wage gain will be substantial. If largely "low wage" jobs are added, the opposite occurs.

So, what is happening to inflation expectations? Has the employment report changed anything? I have shown a way to observe this using StockCharts.com and TIPS prices relative to bond prices. For extra credit, graph this ratio (which we have discussed in class before) using daily data (make it a line graph). Annotate this with comments, print it and add a paragraph of discussion, and hand this in at the beginning of class on Tuesday. I will not accept anything after the beginning of class.

So, Monday morning promises to be very interesting for the stock, bond, and currency markets. It would be very good practice for you to think of what "should" happen, based on economic theory.

Employment Report Effects

The February employment report was released yesterday at 8:30 am. The stakes for the markets were high: too low a number and recession fears would re-emerge, which would hurt the stock market but help the bond market; too high, and the opposite would be a problem, with a reduced likelihood of the Fed easing in the near term.

The payroll employment number that emerged was +97,000, which was high enough to remove recession fears, but not so high that worries of overheating would emerge. This scenario has come to be called the Goldilocks Scenario. Read the following article about all of this. Also, read the chapter on the employment report in the Carnes and Slifer text (The Atlas of Economic Indicators).

The stock market began the day with a healthy rise but gave much of this back by the end of the trading day. This often happens when markets get what they were hoping for (this is a variant of the old saying: Buy on the rumor, sell on the news). So, SUPPORT AND RESISTANCE BOTH HELD.

The principle items that caused a reaction in the bond market were a higher-than-expected rise in average hourly wages and a decline in the unemployment rate to 4.5%. In addition to these, the prior months' employment numbers were adjusted upward (this has been occurring for a while now). So, it is very likely that today's somewhat tepid payroll employment increase will be revised higher with the release of next month's data. All of these factors heightened inflation fears, causing a bond market sell off. The 10-year bond rate rose to just under 4.6%, an increase of 8 basis points for the day. Clearly, the bond market wants the Fed to lower interest rates, and the employment report dashed those hopes (for now at least). I guess the bond market's view of the world should be referred to as "The Three Bears," given the stock market's view.

So the "wildcard" for now is the mortgage market. How far will weakness in the sub-prime market reach higher tiers? It has already impacted the "Alt A" market, and with the tightening of lending standards, it will very likely creep somewhat into the market for prime mortgages. The different perceptions of the future state of the economy held by the stock and bond market centers largely on the answer to this question. For now, at least, it appears safe to say that "all's quiet on the carry trade front." Stay tuned.

An interesting article for you to read is by Jeremy Siegel. He attributes part of the recent volatility in stock markets to "trend following" by technicians. These traders (myself included) often place automated "stop loss" orders below the trend so they can insulate themselves from potentially large losses. Here's how a stop loss order works. You choose a price level at or below which you want to get out of a stock (or index like an ETF). Hopefully your choice is based on where support is. You should place the "stop" a bit below support, so that if a false breakdown occurs you don't get "stopped out," after which the stock begins to rise again. You then place an order stating this with your brokerage account. To automate this, specify the time frame for your order as "Good Till Cancelled," or GTC. Normally, this will remain in effect for several months. If, instead, you specify market day, you are only covered for that trading day, after which the order no longer exists. Specifying GTC thus automates this process so you don't have to remain in front of your computer all the time.

So when trendlines are finally broken in sustained uptrends, many of these stop orders kick in, potentially causing large sell offs, and magnified price declines. Hence the volatility aspects. I doubt that stop loss orders played the major role in the large Tuesday sell off, but they were certainly part of it.

A recommendation when you buy stocks: USE STOP LOSSES, but leave room below support in case a false breakdown occurs. Remember, capital preservation should be a primary factor for you.

Big Drop in the Dow-Jones

This past week saw notable movements in the Dow-Jones Industrial Average ($INDU). We discussed much of this in class (thru Thursday anyway). Friday was not a good day. The DJIA closed down 120 additional points, ending at just over 12,100.

The DJIA has been in an uptrend for many months now (since August 2006), so some sort of correction was called for. Typically, these corrections range between 5 and 10 percent declines. The time frame is variable -- there is not a "typical" correction period. IF, however, a correction ultimately involves a 20% decline, the market is deemed to have changed to a "bear market."

After a week like the one we just went through, I recommend using weekly charts to view trends, etc. The chart shows $INDU weekly (click to enlarge it).

One thing to note: just as there is support for price in a main chart, you can use levels of the RSI to denote whether a trend remains in force. As you can see in the diagram, the uptrend remained in tact as long as the RSI (based on 9 periods) stayed at or above 50 (the demarcation point). Since July of 2006, until this past week, that condition was met.

Look at the large weekly bar, which closed near the low for the week. Not good!! Further note that this large drop occurred on large volume. Also not good!!

There is something that is visible on a weekly chart of $INDU that is not apparent from daily data: a bearish divergence. While $INDU was making higher highs since October of 2006, these were not confirmed by the RSI moving continually higher. Thus the bearish divergence.

Support appears to be around 12,000 (look at the chart). If we fall below this, things will get very interesting. How likely is it that we will move below 12,000? Fairly likely, since even after the horrible week, the RSI is not yet in oversold territory. Ugh! Stay tuned, let's see how this week plays out.

In situations like this, you should look to see if any major (i.e., potentially market moving) economic data will be released this week. The answer is yes -- the labor market numbers for January will be released this Friday. What kind of employment report would lead to further price declines? Increases? Also, don't forget about the bond market.

Today's Employment Report

This morning, the January employment report was released. The consensus estimate for job change was +150,000, partly related to what was considered to be warmer-than-normal weather nationally in January. When the number was initially released, it appeared that employment change was slower than expected: +111,000. BUT, prior months were revised up significantly higher, RULE: ALWAYS LOOK AT REVISIONS TO PRIOR DATA BEFORE ANALYZING THE MOST RECENT DATA POINT. Here is an article about the report that you should read.

Along with employment change, the government released the January unemployment rate (slight rise to 4.6%), hours worked (slight decline), and the change in average hourly wages (+0.4%).

When the employment report is released, market participants attempt to gauge the implications for growth and inflation. As we will see this week, nominal interest rates are a function of both of these, so interest rate implications are critical when this report is released. And, it took a while for the markets to "digest" all that was going on with this report. The graph below shows this, focusing on the 10-year bond rate. It is from MarketWatch.com and has OHLC bars for 15 minute intervals to show more immediate and ongoing reactions. The double vertical line in the middle of the graph denotes the end of trading on Thursday. To the right is Friday (today) and the reaction to the job report. Can you see the obvious manifestation of initial confusion by the market for the 10-year bond rate.? Actually, the relevant question is how can you miss it?

The inflation implications of the report are derived from the behavior of the unemployment rate (it relates to resource utilization) and the hourly wage change (which could put upward pressure on prices when it rises "a lot"). In general, when the unemployment rate falls, this is taken to signal tighter labor markets and upward pressure on wages and prices in the future. Translation: higher future expected inflation. How inflationary depends on where the rate is and how much it changes. The lower the unemployment rate, the more inflationary will be the impact of declines. Similarly, the more rapid is growth in the average hourly wage, the more inflationary is it taken to be. We will see later in the course that productivity should also be taken into account to make a more proper determination of this (called Unit Labor Cost), but productivity data are only released quarterly.

Follow the 10-year rate for the remainder of the day. What ultimately happened? Compare the daily bar in StockCharts.com to the prior day. Also, look at the 10-year on a weekly chart.

Big Story: Sharp Interest Rate Increases Last Week

This coming week we will be discussing and modeling interest rates. Ironically, during the first week of class, the 10-year bond rate went all the way from 4.77% to 4.88%, an eleven basis point increase. That might not sound like much, but it is significant, especially since mortgage rate changes tend to be highly correlated with movements in the 10-year bond rate. Expect to see higher mortgage rates reported next week. Read this story to see more about this.

What we will see this coming week in our model of interest rates is that stronger economic growth pushes interest rates higher (other things being equal). That is what happened Friday, with stronger-than-expected reports on Durable Goods and New Home Sales. There was strong economic data earlier in the week as well.

You can plot the 10-year bond rate on StockCharts.com using the symbol $TNX. Follow the handout material I distributed on Thursday, switch to OHLC bars, but customize the time period (change RANGE) to Select Start/End, and use the time period Jan 22, 2007 through today (that will be Friday). Click on UPDATE. You will see the following graph (without the comments embedded). Click on the graph to enlarge it:
















Q: Is this week's run up in the 10-year bond rate due for a pause, or will it just continue?
A: Use technical analysis to provide an answer to this. Note in the graph how the "interest-rate bulls" (which we will see are actually bond market bears, since higher interest rates mean lower prices) dominated this market from Tuesday - Thursday, as the close each day exceeded the open. On Friday, things reversed, as close > open. So, a momentum shift occurred on Friday. We can also use the RSI indicator to help with this (see handout I gave). First, change the default value on RSI from 14 to 9. I highly recommend that you use 9 in the future. As of Friday, we can see that the momentum had shifted, based on the above discussion, AND the RSI was in the overbought range (RSI > 70). This indicates the likelihood of a short-term pause. IT DOES NOT GUARANTEE ANYTHING, HOWEVER!! We will see if this is what occurs next week.

Q: If the 10-year rate does decline, where is it likely to move to?
A: SUPPORT.

Note that by not just following the close each day, but looking at the high, low, open, and close, we are provided with a great deal of added information and insight. While Friday's close was higher than that of Thursday, the fact that on Friday, the close fell below the open, provides a critical insight that you just can't see by restricting focus (as so many persons do) to closing value only.

British Pound Nearing Record

The dollar has weakened against several major currencies over the past week. One of the most important currencies the dollar has depreciated against is the British pound ($XBP). The US dollar - pound exchange rate is now approaching $2. Using technical analysis, is there any basis to conclude that the current high values will continue to move higher?

First, it is important to establish whether the value the pound is approaching, $2, is a resistance level. To do this, remember the basic rule: Look left. What I have done is to extend as far back as far as my subscription allows (to the late 1980s). When going this far back, it is necessary to use monthly data so the graph doesn't get very messy.

When doing this, first, clear off the moving averages that are on the StockCharts.com graphs (the 50 and 200 period). Experiment with values and find a period that fits the most recent upsurge very well. In the present context, the 48-month moving average does this, as the graph shows (click to enlarge).

Examination of the graph shows that $2/pound is a very long-term resistance level that dates all the way back to the early 1990s. So, I have drawn a horizontal line to designate this fact. Support is the 48-month Moving Average.

Is it likely that the pound will break above its long-term resistance? The answer is yes, in the near-term, though. Note that the RSI is not yet at or above the overbought reading of 70 yet, so this indicates there is more upside possible. Also, below the main graph I have added a graph that shows how far the actual values of the pound are from the 48-month Moving Average. Apparently, 20 is the resistance level for that divergence (note: this is 20 cents). At present, the divergence graph below is not yet at 20, so this also appears to confirm that there might be further upside for the pound.

Remember, this is a likely outcome, not guaranteed. And, if the pound does move beyond its long-term resistance at $2, it will become overbought fairly quickly thereafter, as the RSI is very close to 70. So, whether a move above $2 can be sustained after it occurs is open to question.

As I have stated in earlier posts, use economics to determine whether the move after $2 (if it does occur is up or down). To do this, you must essentially formulate a forecast of the pound. A key factor is US monetary policy. Also, will the European Central Bank raise rates for the Euro zone? If so, relative US interest rates will fall (as the Fed is on hold with rates for now), causing the pound to appreciate further. See if you can identify other factors that will determine likely future values of the pound.

Post Election Info

The election is now over (thank God!!). A sharp market sell off that some had feared failed to materialize. Interest rates have come down about half way from their gain after the employment report last Friday.

There is an excellent article I want you to read by Michael Kahn dealing with political cycles and the stock market. The interesting question he explores is whether the market will be strong for 2007 and 2008, or just 2007. In other words, will a historical pattern hold?

Today, we received the most recent balance of trade data. The September trade deficit fell sharply. Why? Because this is a nominal value, and the price of oil dropped sharply over the period covered by this report. So, while short-term fluctuations in the balance of trade often result from changes in relative US income change (as I noted in class), at times when oil prices rise or fall sharply, large changes occur. Read this article on the balance of trade figure.

Perhaps the most important implication of the balance of trade figure is that it indicates the likelihood of an upward revision to Q3 GDP growth. That's because the initial number we received (+1.6%) uses an approximation (i.e., guess) of the balance of trade deficit, which likely included an overestimate of the value of imports. Remember, imports get subtracted from GDP, so lower imports (due to a drop in oil prices) will add to GDP growth figure.