By Oxford Analytica - 09/18/07 07:53 PM EDT
Tightening credit conditions appear to have exacerbated gathering macroeconomic risks to growth. Markets are focused on whether Fed Chairman Ben Bernanke, facing the first major crisis of his tenure, can contain credit contagion.
The Federal Reserve and Wall Street are scrutinizing economic data in order to determine whether recent turmoil in the financial markets is affecting the real economy. U.S. markets experienced turbulence after enjoying an annualized growth rate of 4.0 percent during the second quarter, up from 0.6 percent during the first three months of the year. The economy benefited from improvements in foreign trade, inventory and capital spending during the second quarter against a backdrop of slower consumer spending. This creates a policy dilemma for the Fed, as market expectations of a significant rate cut have soared despite mixed economic data.
Some positive indicators.
The first third-quarter indicators appeared to be positive. Durable-goods orders rose 5.9 percent in July. Consumer spending rose by 0.5 percent in August. The ISM manufacturing index dipped only slightly, to 52.7 in August from 53.8 in July. The non-manufacturing index remained steady at 55.8. The Fed’s Beige book, published on Sept. 5, also was reassuring.
Bearish employment report.
Yet on Sept. 7, the Labor Department produced an employment report for August that was far weaker than expected, jolting Wall Street:
•Payroll employment declined by 4,000 jobs — the first employment decline in four years — compared to widespread forecasts that it would increase by 100,000.
•Private payrolls grew by 24,000, due to 60,000 new positions in the service sector.
•However, manufacturing employment fell by 46,000 jobs, and construction employment fell by 22,000.
Housing sector drag.
The growth rate of the U.S. economy in the 12 months through the second quarter was 1.9 percent. However, if the residential construction sector had been excluded, the growth rate would have been 2.9 percent. Thus, the housing sector has been the primary drag on growth:
•Housing bear market? Residential construction has fallen from a peak of 6.2 percent of GDP to 4.2 percent. The economy has shed 40,000 jobs in the mortgage sector since January.
•Signals of weakness. Before the surprise September employment report, the first indicators of serious weakness in the economy had centered on the housing market. The pending home sales index in July plunged 12 percent, after rising by 5 percent during June and contracting 3.7 percent in May.
•Snowballing effects. There is widespread concern that falling property prices could depress consumption and that the turmoil in the financial markets could dampen business investment. Retail sales rose a disappointing 0.3 percent month-on-month in August — excluding a discount-driven surge in auto purchases and a temporary fall in gasoline sales, sales would have fallen 0.1 percent. Auto sales have declined from 17 million at the peak of the housing boom to 15.4 million recently.
•Sub-prime meltdown. The crisis caused by irresponsible lending to unqualified borrowers in the sub-prime mortgage market is deepening:
Surging foreclosures. The mortgage foreclosure rate rose to 0.65 percent during the second quarter, the highest level in 55 years. The rate was up seven basis points from the first quarter and 22 basis points from last year. Delinquency rates hit 14.82 percent on sub-prime loans versus 13.77 percent during the first quarter and 11.7 percent one year ago.
Sagging sales. Home sales will suffer from the impact of recent market turmoil on mortgage rates. Since June, mortgage rates for sub-prime loans have increased 300 basis points to 11 percent. As a result of declining sales, there is now a 10-month supply of unsold homes, compared to five months in early 2006. The large stock of unsold homes is depressing prices. The Case/Shiller house price index has now declined by over 4 percent compared to one year ago, and the CME futures market projects that national house prices could decline an additional 4.6 percent.
The recession in the housing industry has evolved into an “information crisis.” Investors perceive that the rating agencies collaborated with investment banks to produce high ratings for a wide range of securities with exposure to sub-prime loans. Following this loss of confidence, investors are now exiting various asset markets, forcing commercial banks to assume new funding burdens. Since Aug. 8, the commercial paper market has shrunk from $2.24 trillion to $1.925 trillion. The financial challenge for the market over the next six weeks will become particularly acute, as $1.3 billion of commercial paper matures on conduits managed by leading European and U.S. banks.
Monetary policy dilemma.
Most observers at the Fed’s Jackson Hole, Wyo., conference in August believed that Fed Chairman Ben Bernanke used his speech there to prepare the way for an interest rate cut tomorrow. Markets now believe that the Sept. 7 employment report virtually guarantees a cut. The only controversy is about whether the Fed will reduce the main federal funds rate by 25 or 50 basis points.
The White House and the Fed are conscious of the risks facing the housing market. President Bush on Aug. 31 announced a program to bolster the housing sector. The Fed, the Federal Deposit Insurance Corporation and the Treasury also issued a statement on Sept. 4 calling upon companies processing mortgage payments to identify homeowners at risk of delinquency when their loans reset to higher interest rates. The government wants lenders to refinance these loans at below-market or below-contract rates.
Resetting mortgage risk.
The government is particularly concerned about variable rate loans because they represent the core of the sub-prime problem. From 2004 to 2006 there were 3.2 million mortgages issued with “teaser” introductory rates below 5.5 percent. Approximately 1.9 million mortgages with teaser deals have already reset to higher rates. However, another 1.4 million will reset in 2008 and beyond; their gross value is $404 billion, or 28 percent of all adjustable rate mortgages. The risk hanging over the mortgage market is that low-income families with teaser rates will find it difficult to sustain mortgage payments when the yield on their loan climbs to 7-8 percent. This could push the default rate on sub-prime loans above 20 percent.
Most Wall Street analysts believe the economy will slow further during the next few quarters but avoid a full-scale recession. There is also an overwhelming consensus that the Fed will ease at least two or three times. This consensus has helped to prevent a sharp sell-off in equity markets, but some sectors could be vulnerable to earnings disappointments. Investors also draw comfort from the strength of the global economy, which is boosting the earnings of multinationals. Fed easing could weaken the dollar, but as other central banks are deferring plans to hike interest rates, the decline is likely to be modest.
Oxford Analytica is an international consulting firm providing strategic analysis on world events for business and government leaders. See www.oxan.com.