US markets expecting too much from the Fed
Until recently, investors and policymakers alike could at least draw some comfort from the fact that the continuing meltdown in the housing market had by and large not spilled over into the broader economy. Manufacturing output had been recovering from its contraction at the turn of the year, while consumer spending remained resolutely upbeat. However, the fallout from the subprime crisis and the surge in the price of crude oil threaten to prove too much for the US economy, already buckling under what is shaping up to be the sharpest contraction in house building for 50 years. House building has contracted from around 6.3% of the US’ annual economic output at the beginning of 2006 to its current level of 4.5%. The continuing collapse in applications for permission to begin new developments suggests house building will contract further.
The squeeze in the credit markets, together with rising foreclosures and bad debts are encouraging banks to cut back on new lending to firms and households. The downturn in factory orders for capital goods – machinery, transport and computers – suggests firms have already begun to cut back on investment. So far, though, the fact that stocks of unsold goods have not been building up in factories or in wholesalers’ warehouses suggests the economy is not teetering on the edge of recession. The US dollar’s slide – the exchange rate has fallen around 13% against the currencies of its trading partners over the past two years – has buoyed foreign orders and the boost to trade should keep the US out of recession. Although the US economy is in for a bumpy ride, the markets appear to be pricing in too much bad news, particularly relative to markets in Europe where investors have been slow to appreciate that activity is cooling. As a result, US stocks look good value compared to other equity markets and relative to government bonds, which have been boosted by investors anxious for a safe haven during the current turmoil.
The Federal Reserve has been reluctant to signal it is willing to cut interest rates again but the renewed squeeze in the credit markets credit is likely to force its hand. Although policymakers expect inflation to fall back to 2% or so in the medium term, they are concerned about the spiralling cost of oil and the dollar’s tumble. Between 1995 and 2004, the cost of imported goods fell, but since then, even ignoring the ever-rising cost of petroleum prices, import prices have been rising. Moreover, although interest rates still look moderately supportive for the dollar, the fragility of sentiment suggests the dollar is likely to slide further. The money markets are discounting the Federal Reserve cutting interest rates to 3.5% by the end of next year, 1.0% below the Federal Reserve’s current policy rate, and in the process dragging two-year yields down to 3.1%, their lowest level in three years. The risk of inflation ticking higher means that US bond markets look over extended relative to other government bond markets, although yields worldwide are likely to continue drifting lower in the current nervous climate. …
