In several of my economic-analysis reports leading up to - and immediately following - the address that U.S. Federal Reserve Chairman Ben S. Bernanke made at the Kansas City Fed's annual economic symposium a little over a week ago, I said that an interest rate cut that Wall Street had been clamoring for was far from certain.
For one thing, Bernanke made it abundantly clear that Fed policymakers were not going to move on short-term interest rates to bail out Wall Street speculators (i.e. the hedge funds) and homebuyers who'd purchased their houses as get-rich-quick schemes, and not as warm domiciles. And with each successive economic report that appeared seemed to underscore the U.S. economy's continued resilience and strength, I cautioned that the likelihood of the clamored-for cut in short-term interest rates was growing increasingly unlikely - even though the stock market has already "discounted" that rate cut into securities prices.
And with the odds of a near-term rate reduction seeming to be so unlikely, I said there was virtually no chance that the central bank would reduce rates ahead of the Sept. 18 meeting of its policymaking Federal Open Market Committee (FOMC). With the growing global credit crunch that's spun out of the subprime-mortgage crisis, many investors actually have been expecting the Fed to act soon to keep the problem from worsening.
In my earlier research notes, I said that the Fed would be carefully scrutinizing both real-time evidence and traditional data, in particular studying each economic report, looking for any indications that the economy was either weaker than thought, or in an outright decline. I didn't think the Fed would find anything strong enough to justify an interest-rate reduction.
But even with those comments, I issued several caveats:
- First, I said that if the troubling economic reports were released, they were likely to roil the markets.
- And, second, I said that if the Fed opted to not cut interest rates - the scenario I was predicting - that could badly roil the markets, too.
So far, I've been proven right on the first count - Friday's stunning and highly worrisome jobs report truly roiled the markets - time will tell if I'm right on the second, too.
Given this development, I believe that Bernanke and the current FOMC board are very conscious of prior Fed errors (more on that in a bit) and will act with appropriate restraint. The upshot: I am now anticipating a quarter-point reduction in the Federal Funds rate following the Sept. 18 FOMC meeting.
We can expect the volatility we're seeing right now to continue right up to and perhaps even through the Fed policymakers' meeting.
Let's take a look at what's providing the fuel for this most-volatile fire.
The Unpleasant Surprise
Friday's employment report had been highly anticipated because U.S. payroll figures are viewed as an early indicator of an economic downturn [To read the Money Morning news report on Friday's jobs report - and the shattering stock-market reaction - click here].
The economy actually shed 4,000 jobs in August, marking the first payroll decline in four years. What's more, the number of jobs added in June and then July were revised downward - by 57,000 in June and 24,000 in July.
Earlier last week, the economic picture had been one of resilience:
- The ISM Index (manufacturing), while lower than the 14-year high in June, still indicated a moderate rate of growth, and an improvement in actual demand and production that lead to sustained in input costs, but with little impact on inflation, because of the globalized economy.
- ISM Services, which came in stronger than expected, showed continued strength and no signs of any weakness.
- Construction, as expected, is slumping, led by residential construction.
- Productivity was strong.
And this picture was reinforced by Fed governor speeches during the earlier portions of last week, each of them pointing to the U.S. economy's actual strength, despite the credit-related financial turmoil.Â In a similar sense, many regional Federal Reserve Bank presidents also indicated that economic activity remained strong in their regions. And the Beige Book Report last Wednesday pointed to a similar story. With all this evidence, nobody could have expected the "shocker" employment Friday morning.
Employment losses for the first time since 2003 - this changes the outlook.
The headline number, minus 4,000 jobs in the August, with major revisions down in prior months left the average gains for the last three months at 44,000 and showed a strong decline in manufacturing of 46,000 jobs and construction of 22,000 jobs.
Since the end of the first quarter, we've been pointing to the high correlation between construction (as measured by finished homes) and employment. And we've been predicting a slowdown in employment, although not of this magnitude.
The size of this decline could very possibly be due to data integrity, which will be revised in coming months, but not enough to bring it to levels consistent with the other indicators we mentioned.
A Look Ahead
What is clear is this: This loss of jobs very clearly points to an economic system that is slowing down, and with a six-month average core PCE deflator [the Fed's preferred inflation gauge] already running near the middle of the Fed's comfort zone, this number gives the Fed tangible evidence to justify starting to cut rates without being seen as bailing out speculators.
In this situation, the interest-rate sensitive businesses (particularly Wall Street investment banks) have continued to clamor for an interest-rate reduction. And on the basis of Friday's jobs-report number, their share prices quickly adjusted to discount additional subsequent cuts ahead.
As I said earlier, as we move close to the Sept.18 FOMC meeting, we will probably experience further market weakness; many investors now believe the Fed to be "behind the curve" - that is, way late in cutting interest rates to stave off a significant economic slowdown or downturn.
I do not agree with this view.
Indeed, as I've also written, if the Fed has learned anything at all about adjusting interest rates to manage the economy, in virtually every similar instance in the past, the market and the Fed have over-reacted to slowdowns and crises, leading later to an over-stimulated economy.
I believe that Bernanke and the current FOMC board are a conscious of prior biases and will act with appropriate restraint this time. As a result, I am now predicting a 25-basis point reduction in the Federal Funds rate on Sept. 18.
This will have a big - and beneficial, I believe - impact on my strategies with the trading services that I manage.
I expect the economy to quickly recover into the end of the year, the heightened volatility that I expect we'll see this week could well provide us with better buy-in points into the stocks that I have been watching with an eye toward purchasing, including:
- Investments in the fast-growing emerging markets.
- Financial-services stocks, which will greatly benefit from expected interest-rate reductions.
- Energy stocks.
- Technology shares.
Related News and Story Links:
Money Morning News Analysis:
Fed Chief Keeps His Options Open.
Money Morning News Analysis:
Fed's Bernanke is Pushing the Right Buttons.
Money Morning News Report:
Fed Cuts Discount Rate; Stocks Rebound.