Follow the Fickle or the Federal Reserve?

Markets are fickle, but traders can be even more fickle. Just as it seemed everyone was unconcerned with inflation readings even as Federal Reserve officials scrutinized inflation measures continuing to be above certain “comfort” levels, traders and the market began to pay attention in 2007. 2006 is over, and 2007 is a fresh slate, will we ignore inflation again or entertain the Fed’s observations?

In my last post, “Inflation Apparently is a Thing of the Past”, I noted that the market was putting positive spins on negative data releases and had dismissed inflation as a factor in the market’s valuation. Effectively, the market was able to close near the highs of the year by neglecting obvious factors that weigh on the economy, such as inflation. Quite possibly no matter what type of data releases were made, the market would have finished 2006 on a positive note. Now that we are in a new year traders may start to pay attention to the factors that have obviously been in play in the Fed’s mind. Let’s take a look at some recent comments from the Federal Reserve
Blast to the past for a moment with me. Recall Tuesday November 28th, Federal Reserve chairman Ben Bernanke gave a speech in New York about the current economic outlook and shared his thoughts that the “level of the core inflation rate remains uncomfortably high” and then made further comments that the “the FOMC reiterated its view that the upside risks to inflation are the predominant risks to the forecast and indicated that it is prepared to take action to address inflation if developments warrant”. Remember, this was less than two weeks after the Core CPI came in down -0.9% for the month of October and the overall CPI came in down -1.6% in October and -1.3% in September. These were numbers that were suppose to relieve some pressure on the chairman, but instead he reiterated his inflation concerns in that speech, along with several other fed officials who reproduced similar comments over the next several weeks. On December 15th, 2006 CPI shot up 2.0% while core CPI rose 1.3%. The market had no reaction; possibly due to traders taking early holiday vacations.
Fast forward to Wednesday January 3rd, 2007; the first day of trading after a day of mourning for President Gerald Ford who recently passed away. It’s a new year and a new perspective on the part of traders who in 2006 ignored inflation during the third and fourth quarters. January 3rd started off with a bang as the Dow Jones Industrial average made intraday record highs prior to the release of the FOMC minutes from December 12th. Bang is right, we got exactly that. The market did a 180 as the FOMC minutes noted that “Readings on core inflation had been elevated, and the high level of resource utilization had the potential to sustain inflation pressures”. Essentially this is exactly what the Fed has been saying since it stopped its rate hiking campaign in August 2006. The S&P 500 fell from 1440 to 1427 (almost 1%) and the NASDAQ actually fell 2.4% in direct result from the release.
If you continued to read the statement further a notable phrase was thrown in near the end of the same paragraph as above. After the “committee judged that inflation risks remained” they further noted that “the extent and timing of any additional firming that might be needed to address these risks would depend on evolution of the outlook for both inflation and economic growth”. Very interesting….the Fed continues to discuss additional firming while both the bond market and equity markets have priced in a rate cut over the next six months. We could be in for a rough first quarter if data released regarding economic growth shows further slowing and inflation remains constant or progress higher.
Well, this morning we had one of our first reports concerning both; the jobs report. Non-farm payrolls came in higher than the expected 100,000 at 167,000. By solely looking at this data, we can see that the economy is continuing along at a solid pace; although slower than the previous few years (see chart below).
The last indicator from the jobs report was average hourly earnings, which are important for a few reasons. First, it measures personal income growth during the period. Second it measures possible increasing/decreasing wage pressures; in other words, wage inflation. The report noted that hourly earnings increased 0.5% (higher than the expected 0.3% increase) followed by an upward revision of November’s number from 0.2% to 0.3%. That leaves the year of year growth at 4.2% which is the largest rate increase since February 2001. It looks as if wage inflation is continuing to move higher in the face of a slowing economy.
Unemployment Rate
All this information leaves a sticky situation for traders and the market itself. With inflation remaining a concern on the Fed’s radar with the incoming data and the market’s already pricing in a rate cut, what is going to happen next is completely in the air? I don’t want to make any predictions, but I like to be informed of the current economic situation and the Fed’s current opinions. I believe the Fed will have to make a move in 2007, but I am not sure that it will be a cut. Upcoming CPI data will be released later this month, yet this number won’t clear up any non-directional bias in inflation measures anytime soon. Until then, it should be an interesting 2007. Happy New Year!
Charlie Santaularia
Managing Director
Parrot Trading Partners, LLC
cell 785.766.0773
office 303.284.9232

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