Driving Interest Rates - February 2002:
Second Fed Rate Cut / Decline in Stocks / Quarterly Refunding / Greenspan
Congressional Testimony
Previous Period Recap: December 15 - January 17
The major event of the previous report
period was the surprise inter-meeting cut to the fed funds rate by the Federal
Reserve on January 3rd. The fed funds rate is the rate of interest banks charge
to each other for overnight borrowings which they engage in to meet reserve
requirements from day-to-day. It is significant in that it is used as a
benchmark for short term rates in general. It also affects longer term rates
because bond traders use short term borrowing to finance their purchases.
The Fed also cut the discount rate, the rate
charged to banks for loans directly from the Federal Reserve. This discount rate
is less significant than the fed funds rate because it is used less frequently
by banks. At first the Fed only cut the discount rate by 0.25% but on the
recommendation of the Reserve Bank branches, cut it a day later by another
0.25%. These cuts helped to underscore the aggressiveness of the central bank's
operation.
The timing accentuating the power of the
move. Even analysts who had forecast an inter-meeting cut cited Friday the 5th
as the likely date for it since the influential, monthly employment report was
due for release on that day. And the extent of the cut was unusually large,
suggesting that the Fed saw the danger of a significant economic slowdown ahead
requiring a powerful stimulus to avoid.
After some technical adjustments to the rate
cut, the bond market declined as stocks, particularly the tech sector
represented in the Nasdaq index, steadily rose. Despite disappointing earnings
projections, stock traders felt optimistic that the Fed would turn the economic
picture around and that the downturn would be short lived. Also bearing on
Treasuries was the influx of competing bond offerings from agencies and
corporations generated by the lower interest rate environment. And the economic
news seemed to suggest that the economic decline might be shallower than
previously thought and that inflation might hamper the rate-cut scenario. Oil
prices were expected to remain high as the Organization of Petroleum Exporting
Countries (OPEC) cut production limits. And although indicators of consumer
feelings were showing a marked deterioration, retail sales showed a slight
increase in December after weak readings in October and November.
But Treasuries bounced late in the report
period on a tame Consumer Price Index reading for December and a third straight
month of negative movement in industrial production. The industrial production
decline for December was the largest drop in two-and-a-half years.
January 17 - February 21
Treasuries came under pressure for the
remainder of January as the Dow rose by about 300 points and the Nasdaq gained
90. But the dynamic reversed in February (up to the 21st) as the Dow fell over
450 points and the Nasdaq plummeted over 500 points. After sweeping through a 30
basis point range, the 10-Year Treasury Note yield was lower on the period by
just 5 basis points. 
The 30-Year Bond yield covered a 31 basis point range and ended just 3 basis
points below where it started.
Supply pressures and the January rise in the
stock indexes pressured Treasuries until the day preceding the conclusion of the
Fed's regular meeting on January 31st. On the 30th, the Conference Board's
Consumer Confidence Index for January posted its biggest drop in over ten years.
The news weighed on stocks as it foreshadowed less spending and lower corporate
earnings. But the news bolstered the bond market as it provided assurance that
the Fed meeting would conclude with another aggressive rate cut.
The Fed meeting concluded with the expected
cut to the fed funds rate of 0.50%, lowering the target to 5.50% from 6.00%. The
Fed also cut the largely symbolic discount rate by 0.50% to 5.00% from 5.50%.
Treasuries rallied on the news which was
given further force by the economic news released that day. The first official
estimate of the gross domestic product for the fourth quarter was lower than
analysts had forecast. The gross domestic product is a measure of the total
market value of final goods and services produced within the country and is the
broadest gauge of economic activity. Also released that day was the Chicago
Purchasing Managers Index which was also lower than expected. The news suggested
that the Fed would need to continue stimulating the economy in order to avoid a
recession. This conclusion was further supported the next day by the National
Association of Purchasing Management Index for January. The index fell for the
sixth straight month and indicated that the manufacturing sector was contracting
at an accelerating rate.
The decline in stocks helped the bond market
absorb the Treasury's quarterly refunding supply. On February 6th, $11 billion
in 5-Year Notes were issued and on the 7th, $11 billion. But both the stock and
bond market was disappointed when Fed Chairman Alan Greenspan presented his
semi-annual report to Congress in his testimony to the Senate Banking Committee
on February 13th. While Mr. Greenspan did not give any indication that the Fed
monetary policy committee would not cut rates again at its next scheduled
meeting on March 20th, he presented what the markets perceived as a generally
upbeat view of the economy.
Later that week, bond traders were taken by
surprise by a stronger than expected Producer Price Index for January. The PPI
is a gauge of wholesale prices and is watched for signs that inflation pressures
may be building for the retail level. The jump in the headline number in the
January PPI was the largest in over ten years. In addition, the core index,
which excludes the volatile food and energy components and is considered a more
stable indicator of underlying price changes, also rose dramatically.
Initially, Treasuries fell sharply on the
news, but the inflation indicator was contradicted by news of another decline in
industrial production. Slowing production suggests reduced demand for raw
materials. And the report also showed another reduction to the ratio of output
to production capacity, or capacity utilization. This too suggested a lack of
pressure on retail prices since there was no production bottleneck.
The decisive piece of news that offset the
PPI surprise was provided by lowest reading in the University of Michigan's
Consumer Sentiment Index since February of 1996. The news was particularly
influential given Mr. Greenspan's testimony, in which he said that consumer mood
would play a crucial role in the economic recovery.
All of this information, combined with a
continuing string warnings regarding corporate earnings, sent stocks sharply
lower, also helping bonds as investors took money out of equities and into the
safety of the Treasury market.
On February 21st, The Labor Department
reported that the Consumer Price Index (CPI) for January rose much more overall
than analysts had predicted. At the core level, the rise was more in line with
expectations. But the headline number was not entirely unexpected since the PPI
had come in high. And whereas the report usually has a significant impact on the
bond market, its force was blunted somewhat by the fact that the focus of the
Fed policy committee had shifted from guarding the economy against inflation to
guarding against weakness. Inflation in itself, however, is a negative for bond
values, regardless of its effect on Fed policy. A reduction of the value of
dollars to be paid out on the securities reduces the current value of the
investment. The longer the security is exposed to inflation, the more vulnerable
it is to inflation. This factor weighed on the long end of the market on the
21st while new supply in the form of a Treasury auction of $11 billion in 2-Year
Notes weighed on the front end.
In the housing sector during our review
period, indicators were predominately strong. In December, housing starts rose
slightly though a decline had been anticipated. Analysts noted, however, that
starts for the year were the lowest they have been since 1997. Later in our
review period, the January report on housing starts showed a strong increase. A
spike in building permits also suggested future strength in starts activity.
Construction spending also rose unexpectedly
in December versus an expected decline. But the report showed that residential
construction fell for the third straight month.
Another sign of strength was revealed in the
National Association of Homebuilders Housing Market Index for February. The
index rose for the month after two months of deep declines.
But the National Association of Realtors
reported that existing home sales fell in December. Since the sales trend had
been generally declining August, this appeared to be at least one sign that the
economic slowdown was having an effect on consumer confidence.
Lower mortgage rates were generating in
increase in refinance activity as measured by the Mortgage Bankers Association
application survey. The refinance index rose about 180% from December's average
to January's and about 240% between December's average and the first half of
February. The percentage of refinance versus purchase applications rose from
around 20% in September to about a 60% average.
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