As the Economy Improves, the Fed Recalibrates its Message

As the economy and labor market improve, quantitative easing (QE) is wound down and the first rate hike draws nearer, the language of the Fed evolves accordingly.  Both the minutes of the June FOMC meeting and the remarks of Fed Chair Janet Yellen at Jackson Hole were incrementally less dovish than earlier language.  The pace of these changes suggests that the Fed is comfortable “the ball is in the fairway”…the likelihood of a surprise policy shift is low.

The Fed is managing risk very carefully.  It doesn’t want to tighten too soon.  The submarine captain doesn’t want to dive when most, but not all, of the hatches are closed. The Fed seems to be shifting its focus from the unemployment rate to measures of wage inflation…that shift might justify their keeping rates lower for longer.

Housing: encouraging sign of market healing.

  • Existing home sales ticked up to 5.15 million seasonally adjusted annual rate (SAAR)…still modestly below year-ago levels, but firming up.
  • Housing starts rose from a 0.94 million SAAR to 1.09; permits rose from 0.97 to 1.05.
  • The National Association of Home Builders (NAHB) builder outlook index rose from 53 to 55, powered by the Midwest.
  • Mortgage applications (demand) remains soft; the generic mortgage rate is 4.29%.

No economic weakness warnings here.

  • The LEI (index of leading economic indicators) rose more than expected, even after upward revisions to each of the prior two months.
  • The Markit U.S. flash manufacturing PMI rose from 56 to 58.
  • The Philly Fed index rose from 24 to 28.
  • Initial unemployment claims declined to 298k…anything below 300k is good.
  • The AIA Architecture Billings Index, a leading indicator of construction activity, rose to 55.8, its highest level since 2007.

No inflation warnings here.

  • Core and Headline CPI were 1.9% and 2.0%, respectively.  Comment: Yellen can stand vindicated for saying she wanted to wait to be sure an earlier acceleration wasn’t just a transient spike…it looks increasingly as if it was.

Markit’s international flash PMIs are flashing warning signs.

  • The Markit flash August Eurozone composite output index slid from 53.8 to 52.8; services fell from 54.2 to 53.5; manufacturing from 51.8 to 50.8.  That’s the 14th month above 50, but a 13-month low.
  • China’s flash PMI slid from 51.7 to 50.3, a three month low.
  • Japan’s flash purchasing PMI ticked up from 50.5 to 52.4…relatively encouraging.

Capital Markets: Another quiet week in August: stocks rise despite escalating conflicts.

  • Wall of worry watch: The Ukraine conflict escalated. The Gaza conflict escalated. The ISIS conflict escalated. Markets didn’t really seem to care all that much.  Fedspeak (minutes and Jackson Hole) didn’t roil markets.
  • Equities: The S&P 500 Index set another new high, ending the week up 1.7%. Only Telecoms (-0.4%) and Energy (+0.6%) lagged notably. Four sectors (Consumer Discretionary, Financials, Industrials, and IT) returned 2.2%-2.4%. Internationally, the MSCI Europe Index was up 2%, the MSCI Japan Index 1.2%, and the MSCI Emerging Markets Index 1%.
  • Currencies: The dollar continues to appreciate against the Euro and Yen, consistent with higher U.S. economic growth and expectations that the Fed will raise rates first.  The Euro has now fallen from a March-May high of $1.39 to $1.32. The Yen began the year at 105/dollar and is now at 104.
  • Bonds: Bond markets were quiet, but repriced for stronger growth. The 2-year Treasury’s yield rose 11 basis points (bps), from 0.42% to 0.53%. The 10-year Treasury’s yield rose 6 bps to 2.40%; the 10-year TIP yield rose 8 bps to 0.24%. Corporate bonds rallied: the option adjusted spread (OAS) of the BoA Merrill Lynch High Yield Index fell 18 bps to 3.79%.
  • Global bond markets were quiet: Japanese 10-year yields remained at 0.50%.  German 10-year yields rose 3 bps to 0.98%.  Intra-Eurozone sovereign spreads were quiet.
  • Commodities: Bad news for commodity bulls, but good news for consumers of food and energy.  WTI oil fell roughly 4% to $94.  Gold fell another $17 to $1,277; it’s now more than $100 below its March peak.  Agricultural and livestock commodity futures fell again; a large harvest is forecast.  The GSCI index, up strongly in the spring, is now below break-even for the year.

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About Sam Wardwell

Sam Wardwell, CFA, is Senior Vice President and Investment Strategist at Pioneer Investments. He joined Pioneer in 2003.
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