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Economic trends.


The first Thursday of each month is often a day of great anticipation in credit markets. The reason is simple. On Friday morning, at 8:30 Eastern time, the Department of Labor releases the employment report for the previous month and provides fresh news on how the economy is doing. On Friday, January 4, market participants expected nonfarm payroll employment for December to fall about 150,000; instead, it declined about 75,000 - only half of what was expected. A sell-off in the bond market ensued that drove bond prices down and, consequently, pushed interest rates up sharply. Why did the market respond in this fashion? The answer is straightforward. Credit markets respond to key economic indicators because these indicators shed some light on the direction of the economy and give clues about how the Federal Reserve is likely to conduct monetary policy in the coming months. The smaller than expected decline in employment suggested that the economy might not be as weak as previously thought, that inflation might not decelerate as much as hoped, and that the Fed might not ease further in the short run.

The key to short-run fluctuations in credit markets is what market participants expect versus what the statistics actually show. If the statistics turn out to be as strong or as weak as markets expected, markets will not respond very much because those expectations have already been incorporated into bond prices. An analogy to the stock market may be helpful in illustrating this point. Before a company is taken over, there are almost always rumors of the takeover and speculation about the takeover price. Investors buy on the basis of these expectations, and the stock price moves toward the expected takeover price long before a takeover is announced. The actual announcement of the takeover only affects the stock price if the actual takeover price turns out to be different from what markets had anticipated.

Economic statistics influence credit markets in much the same way. If the statistics show surprising economic developments, the markets will react very strongly.

Not all reports are equally important; the eight most influential reports currently cover: the employment situation, the purchasing managers' survey, retail sales, producer prices, consumer prices, merchandise trade, durable goods orders and gross national product (GNP).

The employment situation, prepared by the Bureau of Labor Statistics of the Department of Labor, and the purchasing managers' survey, prepared by the National Association of Purchasing Management, are released early in the month and provide the first summary statistics on economic activity in the previous month. The employment situation is perhaps the most consistently influential of all the nation's statistical reports because it provides so much information on employment trends and industrial patterns. Further, it is very timely. The unemployment rate is the most visible single statistic from the report, but changes in nonfarm payroll employment are viewed by most credit market participants as the key indicator from the report on the direction of economic activity. Changes in manufacturing employment, a component of total payroll employment, are also viewed with great interest because they provide intelligence on the underlying industrial strength of the economy.

The purchasing managers' survey is influential because it provides an early view of manufacturing activity, often several days before the employment report is released. Its value rests on its timeliness; it is usually the earliest piece of evidence on economic activity in the preceding month.

Retail sales, prepared by the Commerce Department around the middle of the month, provide data on consumer purchases of goods in the preceding month. The report is influential because sales of goods constitute an important part of total personal consumption expenditures, which account for about 2/3 of the nation's economic activity.

The producer price index (PPI) and the consumer price index (CPI), both prepared by the Department of Labor around the middle of the month, provide information on inflation rates in the preceding month. The PPI, released first, provides information on producers' prices at a variety of stages in the production process - raw materials, intermediate materials, and finished goods. The finished goods index is usually the center of attention. The CPI provides information on changes in prices for consumer goods and services. Both reports contain some very volatile components, particularly with respect to food and energy prices. For this reason, credit market participants often focus on index changes excluding the food and energy components to get a better reading on the underlying inflation rate.

The merchandise trade balance, prepared by the Department of Commerce around the middle of the month, reports imports, exports and the trade deficit of two months earlier. Even though the report is not very timely, it has become one of the most influential in recent years because of the growing importance of international trade to the U.S. economy.

Larger than expected increases in the trade deficit imply that the foreign exchange value of the dollar may be too high and that it may decline in the future. If the dollar falls, foreign investors are less attracted to dollar-denominated assets in the U.S. because a declining dollar means that the investor may lose money converting back to their currency at a later date. Further, a declining dollar means that prices of imported goods are likely to increase, contributing to price inflation in the U.S. Both of these influences contribute to falling bond prices and higher interest rates.

Durable goods orders, prepared by the Commerce Department toward the end of the month, report new and unfilled manufacturers' orders for durable goods, together with shipments of these items, in the preceding month. The report is extremely important because orders tell us a good deal about the course of production and related economic activity in the coming months.

Finally, GNP, prepared by the Department of Commerce toward the end of the month, provides the broadest measure of economic activity in the U.S. GNP is a quarterly series; consequently, monthly releases involve four new quarterly estimates each year and eight revisions to previous estimates. Sometimes the revisions impact markets, but typically it is the initial release for each quarter that is the most important.

Generally speaking, unexpected strength in any of these indicators will result in sell-offs in credit markets (i.e., declining bond prices and rising interest rates). Conversely, unexpected weakness will result in heightened demand for bonds, higher bond prices and lower interest rates. Again, differences between expectations and actual results determine the extent of shortrun bond market responses. Occasionally, there are mitigating factors that overwhelm these short-term responses; but as a rule, credit markets respond as described.

In the instance of the smaller than expected December employment decline, the 30-year Treasury bond fell more than 1 1/8 points; a larger than expected decline in durable goods orders (-10.5 percent in November versus -3.0 percent expected) resulted in nearly a 1/2 point rally; retail sales in December came in about as expected, with a modest decline and bond prices did not change.
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Author:Holloway, Thomas M.
Publication:Mortgage Banking
Article Type:column
Date:Feb 1, 1991
Previous Article:Secondary market.
Next Article:Paper is down, but not out.

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