Economic & Market Update: August 25, 2008

“Back to School!”

Chip Norton, Managing Director of Fixed Income & Economic Analysis

US Gold: 30

Silver: 36

Bronze: 35

Last Week’s Highlights:

Stocks:                               Dow struggles at 11.5k

Bonds:                               Treasury level at 10-yr 3.85%

Oil:                                    Spike on Russia - $121

Gas                                    Still lower - $3.681

Dollar:                               Dollar rally to 1.47 euro, 110 yen

PPI                                    Higher than expected, 9.8%

Housing Starts                 Down again

Leading Indicators         Down a bit more than expected

Economics This Week:

Date      Item                                  Est.                     Comment

8/25      Existing Home Sales     4.90m                  Uptick expected

8/26      New Home Sales           523k                    Downtrend continues

8/28      GDP Q2                          2.7%                    Revision upward seen

Hard to believe this week wraps up August and the one year anniversary of the start of the credit market implosion. I’m not sure there is anybody in the markets, except those aggressive shorting folks, that will want to mark it on the calendar to recognize it ever again.  Even a year later, credit conditions are tenuous at best. Yes, there is stability and trading flow now, but the sub-prime fallout continues to plague many firms – just ask the folks at Lehman Brothers for example. Most banking analysts suggest that it may take another full year of write-downs, write-offs and layoffs to fully digest the train wreck that started in 2007.  Ok- enough of the gloom, most of our kids are back in school or off to college, so there should be at least some celebration right?

Here’s the goods news -This week’s GDP report for Q2 is expected to show a very robust 2.5% level.  That’s up from the 1.9% from the preliminary report and continues to point toward further recovery in the US. Also, the estimates for Q3 are looking good with talk of another 2.5% to 3% level. Yes, we may get some further downside revisions from Q4 and Q1, but that’s history we’ve already lived – kind of “been there, done that.”  A good GDP number, some further rebound in the dollar and rates holding at low levels should all act as support for better market returns in the near-term.

Oil Acts Rationally

Last week, I indicated that despite the crisis in Russia oil was still backing down in price. Indeed I was a bit shocked that such an event could take place without oil having a good surge higher, say $10.  Well, just a week later and that $10 spike is well on its way as crude has now risen close to $7 in just a few trading sessions. Clearly, the tone taken by the Russian government in recent days on Georgia and with respect to the Poland/American missile agreement has many folks nervous about Russia’s and Mr. Putin’s objectives. I guess lower gas prices were just too good to be true!

Inflation Expectations Back Down

After reaching higher and higher over the last few months, expectations for building inflation have started to back down. A look at the chart below shows how the market prices inflation via the consumer price index swap curve.  While not perfect, you can clearly see the spike higher in July as oil reached the $148 level. At that time, the 3-yr CPI swap reached almost 3.5%. Today, it’s pricing closer to 2.4%, a full 100 bps lower.  Another way to gauge inflation is using the difference between a 10-yr Treasury bond and a 10-year TIPS. This spread is viewed as the implied inflation priced by the market or implied break-even point.  As of this week the 10-yr bond is yielding 3.85% while the 10-yr TIPS stands at 1.68%, a spread of 2.17%. The Cleveland Fed creates a TIPS spread chart that closely mirrors the CPI Swap curve (nominal line and adjusted for inflation line). Based on the adjusted TIPS spread, the market break-even or implied inflation is closer to 2.8%, but has exhibited the same downward trend as the CPI swap curve.  These are both good signs that the anxiety is at least starting to abate, which in turn should help interest rates stay at reasonable levels in the near-term.

TIPS Spread

Source: Cleveland Fed

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