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December 15, 2005

Not Accommodative?
by Chad Hudson

The Federal Reserve finally significantly changed the wording it is statement when it raised the target rate to 4.25%. It no longer describes monetary policy as accommodative. It also added the word "some" when describing further actions. These two changes were quickly translated to mean that interest rates are now in a neutral area and there will be only one, maybe two more rate hikes. The Fed also hinted that its focus will be on employment levels when it said, "possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures." Most economists have dismissed the idea of wage inflation. They usually cite the fact that unit labor cost only increased 1.8% in the third quarter. However, there have been numerous reports, including the Federal Reserve's own Beige Book, that have discussed a tight labor market, especially in certain industries like energy. And, the Department of Commerce has reported the personal income increased 5.3% in November.

So now the Fed thinks monetary policy is in the neutral zone. While the Fed has raised rates thirteen times over the past two years for a total of 325 basis points, the target fed funds rate is only 125 basis points higher than where rates bottomed during the recession in the early 1990's. Following the early 1990's recession, the Fed took the target rate from 3.0% to 6.0% in just over a year. Much quicker than the 25 basis point steps Greenspan has taken over the past eighteen months. In 1994, higher short-term rates pushed long-term rates up as well. Yields on the 10-year Treasury jumped from about 5.5% to around 8.0%. Since the Fed first started raising rates on 6/30/04, the 10-year Treasury yield has actually dropped from 4.58% to 4.46% today. Plus inflation, as measured by the CPI is higher now than during the mid-1990s. Economic growth is also stronger. For the past eight quarters, nominal GDP growth has been over 6.0%. This is the longest stretch since the thirteen quarters ending June 1990.

Considering that residential real estate is ground zero for the current liquidity boom, it seems obvious that slowing mortgage credit would be a top priority. So far there is only preliminary indications that housing has started to moderate. The current tightening cycle has done nothing to raise long-term rates. Additionally, higher short-term rates have not caused much of a reduction in the percentage of mortgage applications that are adjustable. Last week, 33.5% of mortgages were adjustable accounting for 48% of the dollar volume. The peak was set in March when 36.6% of mortgages were adjustable and accounted for 52% of the mortgage dollars. With adjustable rates not much lower than fixed rates, this should be a clear indication that more buyers are stretching to buy a more expensive home.

While one more rate hike is almost guaranteed, fed fund futures have priced in the chance of two more consecutive rate hikes at only 50%. In fact, the chance of rates hitting 4.75% by August is down to about 70%. Just a month ago, it was pricing in a 30% chance of 5.0% fed funds.

This week, Standard & Poor's downgraded General Motor's debt rating to B from BB-. This was the fourth downgrade this year and is the lowest rating the automaker has ever had. S&P said that, "if recent trends persist, GM could ultimately need to restructure its obligations despite its currently substantial liquidity and management's statements that it has no intention of filing for bankruptcy." According to Moody's, about 30% of B-rated bonds default within five years.

Retail sales increased 0.3% in November compared to October. Excluding autos, sales last month dropped 0.3%. While this was the largest contraction since April 2003, sales are 8.7% higher than last year. Consumers have clearly slowed spending lately, but it remains a stretch to describe it as weak. Every time economic data points to growth slowing, it is described as weak. This has recently happened in consumer spending. Consumer spending has been surging for over a decade. Even during the short recession at the beginning of the decade, personal consumption never declined. The fact that it has started to plateau does not mean spending is weak. Consumer spending will undoubtedly get weak, but this is not it. And unfortunately, retailers will fare worse as the surge in spending led retailers to aggressively expand.

Perhaps one casualty of the aggressive retail build out will be Best Buy. This week, the leading electronics retailer surprised analysts when it reported third quarter earnings on Tuesday. Same store sales increased 3.3% and the customer-centric stores increased sales by 5.4%. Last quarter, the difference between the regular stores and the remodeled stores was 590 basis points. It is also worth pointing out that luxury items continue to perform very well. Same store sales at its Magnolia stores increased 19%. While sales were near analysts' estimates, earnings were 7% lower than expectations. While gross margins increased, operating margins were pressured by upgrading stores to its customer-centricity format and building out is service business, Geek Squad. The company also blamed its operations in Canada, citing an increased promotional environment. This seems a tad disingenuous since about 10% of revenues are derived from Canada. There has been a huge increase in gift card sales. With it the number of unredeemed gift cards has soared as well. Best Buy took a gain of $29 million ($0.04 per share) on its initial recognition of "gift card breakage." The company said it expects to recognize $0.02 per share each year as gift cards that are two years old are considered unlikely to be redeemed. Best Buy is the second significant retailer to take this gain. Home Depot did it earlier this year to the tune of $43 million. This will likely be a trend in the near future, so expect a few more pennies per share during earnings season.

With the Fed signaling that the rate increases are coming to a close, it seems appropriate to republish the list of financial crisis that have ensued with each Fed tightening cycle since 1970. This was provided by our friends at ISI group.

Fed Tightening Cycle Financial Crisis
1970 Penn Central
1974 Franklin National
1980 First Penn / Latin America
1984 Continental Illinois
1987 Black Monday
1990 S&L Crisis
1994 Mexico
1997 Pac Rim / Russia / LTCM
2000 NASDAQ

Chad Hudson
Mid-Week Analysis
PrudentBear.com

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