MarketView for April 22

 

 

 

Summary 

 

After being in negative territory for most of the day, the major equity indexes rallied late in the trading day and when it was all said and done, there was black ink all around as strong quarterly earnings from Starbucks outweighed worries about Greece's shaky finances. The cost of insuring Greek debt hit a record high after the European Union said Greece had larger budget deficits last year than anticipated.

 

Moody's downgraded Greece's sovereign ratings, fanning investors' fears that European national debt problems could derail the global economic recovery.

 

Starbucks and SanDisk both posted results that beat estimates. As a result, Starbucks ended the day up 7.3 percent at $27.25, while SanDisk rose 12.3 percent to $42.22. Hershey's profit nearly doubled and its shares rose 7.2 percent to $48.08.

 

Now it looks as if first-quarter earnings are on track to set a record for the percentage of companies exceeding pre-established estimates. Eighty-five percent of the 98 S&P 500 companies that have reported so far have managed to do better than expected, well above the approximate 61 percent you would see during a typical earnings season.

 

Data pointing to further stabilization in the labor market added to the positive tone and helped reinforce optimism with regard to the economic recovery. Large manufacturers also fared well, with Boeing up 2 percent at $75.59. Apple also contributed to the strength in technology shares, rising 2.8 percent to finish at $266.36, another record close.

 

After the bell investors received another round of earnings news but this time the announcements appeared to temper some of the optimism seen earlier in the day. Amazon issued a forecast for quarterly revenue and profit that disappointed investors, sending its shares down 6 percent in after-hours trading.

 

Microsoft, a component of the Dow Jones industrial average, posted a stronger-than-expected 35 percent rise in quarterly earnings, but its share price fell about 5 percent after the bell to $29.83 as a result of Wall Street expecting an even stronger performance.

 

During the regular session traders said investors were encouraged that a speech on financial reform by President Barack Obama carried no new anti-Wall Street barbs.

 

Initial weekly claims for state unemployment benefits fell by  24,000 claims to a seasonally adjusted 456,000 claims, the Labor Department reported Thursday morning, resuming a downward trend that had been interrupted by the Easter holiday.

 

A separate report showed sales of previously owned homes rose 6.8 percent to an annual rate of 5.35 million units in March as buyers tried to take advantage of a tax credit for home buyers, the National Association of Realtors said.

 

Economic Data Mixed

 

The number of U.S. workers filing new claims for jobless aid fell last week as the labor market gradually heals and producer price data showed inflation remained muted, despite a surge in food costs last month.

 

In other data, sales of previously owned home rose 6.8 percent to an annual rate of 5.35 million units in March as Americans rushed to take advantage of a tax credit for home buyers, the National Association of Realtors said.

 

Analysts said the data on Thursday pointed to a moderate economic recovery that should see the Federal Reserve renew its pledge to keep benchmark interest rate exceptionally low for an extended period at its regular two-day meeting next week.

 

Initial claims for state unemployment benefits dropped 24,000 to a seasonally adjusted 456,000, the Labor Department said on Thursday, resuming a downward trend that had been interrupted by the Easter holiday. That compared to market expectations for 455,000.

 

The data covered the survey period for the government's closely monitored employment report for April, which will be released on May 7.

 

While initial claims are still above levels viewed by analysts as in line with job market stability, anecdotal evidence indicates employment is slowly rising.

 

Last month, the economy recorded its largest jobs gain in three years, largely driven by private sector hiring as employers started to warm up to the economy's recovery -- which is showing signs of gathering momentum.

 

Analysts expect the hiring trend continued in April, also supported by recruitment for the 2010 census.

 

The number of people still receiving benefits after an initial week of aid fell 40,000 to 4.65 million in the week ended April 10, the Labor Department said. However, it was less than market expectations for a fall to 4.60 million and the prior week's figure was revised up.

 

In a second report, the department said prices paid at the farm and factory gate increased 0.7 percent following a 0.6 percent drop in February on strong food and gasoline costs.

 

The Labor Department said 70 percent of the increase in wholesale prices in March was due to a 2.4 percent jump in consumer foods, the largest rise since January 1984. Gasoline prices rebounded 2.1 percent from a 7.4 percent fall in February.

 

Still, inflation pressures remain benign. Stripping out volatile food and energy costs, core producer prices gained 0.1 percent in March after rising by the same margin in February. Meanwhile, government data last week showed consumer prices barely increased in March. A combination of benign inflation pressures and excess resource slack in the economy support the Fed’s commitment to low interest rates. The Fed will hold a regular two-day policy meeting on Tuesday and Wednesday next week.

 

In a separate report, sales of previously owned home rose 6.8 percent to an annual rate of 5.35 million units in March as Americans rushed to take advantage of a tax credit for home buyers, the National Association of Realtors said.

 

Despite the rise, activity remained severely depressed from levels preceding the country's sharpest housing downturn in modern history. High home vacancies are constraining rentals, helping to put a lid on inflation.

 

Home prices fell 0.2 percent on a seasonally adjusted basis in February and dropped 3.4 percent in the year, the Federal Housing Finance Agency said on Thursday. The regulator's price index, calculated using purchase prices of homes financed with mortgages that have been sold to or backed by Fannie Mae or Freddie Mac, has fallen 13.3 percent below its April 2007 peak.

 

Economic Data from Greece Worse than Previously Thought

 

Greece's budget gap last year was worse than feared, the European Union's statistics office indicated on Thursday, as Moody's Investors Service downgraded its rating of Greek government debt. The news triggered a fresh slide of asset prices in Greece and other debt-choked European countries, and increased pressure on Athens to seek billions of euros of emergency loans from the EU and the International Monetary Fund.

 

Greece's two-year government bond yield soared four percentage points to 12.26 percent as investors bet the country would need a bailout to avoid restructuring its debt or defaulting. Athens will have to refinance 8.5 billion euros ($11.3 billion) of bonds maturing on May 19.

 

On Thursday evening, Prime Minister George Papandreou was in the seventh straight hour of talks with ministers on how to handle the crisis. It was unclear whether an announcement would be made after the meeting.

 

The budget figures were announced as tens of thousands of Greek nurses, teachers and other public workers staged a one-day strike to protest against the government's austerity measures. More than 10,000 civil servants and students marched to parliament, demanding that Athens reject any pressure for further spending cuts in crisis talks that it launched this week with the EU and the IMF.

 

The Greek government posted a budget deficit of 32.34 billion euros or 13.6 percent of gross domestic product in 2009, not the 12.7 percent which it had reported earlier, Eurostat said in a review of countries' deficits throughout the region. It added that the Greek deficit might be revised again, by between 0.3 and 0.5 percentage points of GDP, because of uncertainty about the quality of Greece's data and accounting procedures.

 

In a brief statement, the Greek Finance Ministry insisted the new numbers would not change its intention to shrink the deficit by four percentage points this year. It said measures already taken would be enough to cut the deficit by six points.

 

Both Athens and EU officials appeared to be backing away from a previously announced target for Greece to slash the deficit to 8.7 percent of GDP this year. Some revision to the 2009 budget gap had been expected, and several analysts said Athens might still succeed in cutting its deficit sharply this year.

 

However, the financial markets were hit hard by the revision because inaccuracies in Greek data, some of them apparently deliberate and politically motivated, have fueled its debt crisis by angering investors and Greece's EU partners. Last October, the incoming socialist government said Greece's 2009 budget deficit would be twice as big as previous estimates -- and four times the EU ceiling. The Greek Finance Ministry attributed the latest revision to a deep recession, which reduced GDP more than expected, and a reassessment of the financial accounts of pension funds.

 

Moody's cut Greece's sovereign rating by one notch to A3, placing it four notches above "junk" status, and kept the new rating on review for a possible further downgrade. "There is a significant risk that debt may only stabilize at a higher and more costly level than previously estimated," it said. Other rating agencies were even harder on the country with Standard & Poor's at BBB+ and Fitch at BBB-.

 

Greece's two-year government bond yield has soared nearly 11 percentage points from just 1.38 percent before the crisis erupted last November. The 10-year bond yield hit 9.17 percent on Thursday but rose more slowly, increasing the inversion of the Greek yield curve -- a classic sign that investors fear Greece may have trouble servicing its debt.

 

The cost of insuring five-year Greek government debt against a default through credit default swaps shot up to the highest level in Europe, surpassing Ukraine.

 

The euro sank almost 1 percent to near one-year lows against the dollar, as investors worried that the Greek crisis had exposed severe economic strains within the euro zone and member states' difficulties in coordinating policies.

 

The markets think Greece will almost certainly have to apply for a 40-45 billion euro aid package from euro zone states and the IMF -- though the German public's opposition to helping Greece could delay the disbursal of funds by Berlin.

 

Austrian Finance Minister Josef Proell said Athens was apparently unwilling to accept conditions that would be attached to the aid, and was therefore hesitating about applying for funds. But he added that "the time for action is now."

 

Greece may get a short-term bridge loan from European countries before the EU/IMF aid package is activated, a senior Greek government source told reporters, though he stressed his comment was theoretical and there was no need for such action. Even if Greece was able to obtain 45 billion euros in emergency loans, it might need tens of billions of euros in additional aid over the next year.

 

Fed May Start with Reverse Repos

 

The Fed could begin draining bank reserves, via transactions known as reverse repurchase agreements, or repos, in large increments as early as this summer. In a reverse repo, the Fed temporarily removes funds from the financial system by borrowing the money from large primary dealer banks. In so doing, though, the Fed could unduly expose itself to the same risks as other investors in short-term money markets, according to some experts.

 

Specifically, the Fed could begin utilizing repos before it openly abdicates a commitment to keep interest rates low for an "extended period" since, technically speaking, reverse repos do not constitute an actual rate hike.

 

Repos would be a first step for the Fed to begin scrolling back on the extraordinary measures undertaken during the height of the financial crisis to support the economy. However, in doing so the Fed would be undertaking some risk. The Fed may conduct fairly large tests of such transactions, known as reverse repurchase agreements, before it drops the "extended period" phrase on low rates from its policy statement, says William Dudley, president of the New York Fed, which oversees market operations. One such dry-run spooked markets back in October.

 

If the Fed launches a fresh round of vaguely defined tests, at a time where the market is already on edge about the possibility of higher borrowing costs, it might have much the same depressive effect on U.S. stocks and Treasury bonds, particularly since they would likely be interpreted as a sign of coming measures to tighten monetary policy.

 

Reverse repos also expose monetary affairs to what traders like to call "event risk." If any of the string of repos required to pull liquidity out of the system fails to find enough demand, for instance, investors might question the Fed's ability to exit successfully from its extraordinarily simulative stance, potentially stoking inflation and pushing market rates sharply higher.

 

Naturally, expectations about when the Fed might pull the trigger on its first large-scale repos vary according to predictions about the direction of rates. But some primary dealers expect large-scale, non-test reverse repos to make their way to the market by summer.

 

Markets have already proven jittery at the mere intimation of higher rates, interpreting a rise in the discount rate charged for emergency loans as a baby step toward tightening and pushing borrowing costs higher accordingly.

 

The central bank has said it is working on ways to use some of the mortgage-backed debt it acquired during the financial crisis as collateral for reverse repos, which would be aimed at preventing excess liquidity in the markets from sparking inflation and, possibly, asset bubbles.

 

Estimates vary as to the frequency and size of such operations. The typical length is overnight, but they can be for as long as 65 business days.

 

So why are reverse repos needed? One way to think of them is as a safety blanket for policy makers, who by any measure are operating in uncharted territory.

 

Given the sheer enormity of excess bank reserves, which mushroomed from around $5 billion-$8 billion in the months leading up to the crisis to over $1.1 trillion at latest count, some Fed officials worry that the benchmark federal funds rate might not react to an increase in the interest on reserves.

 

This fear of the unknown has some foundation. Presumably, if the financial system is still flooded which cheap funding, simply saying that borrowing should be more costly might not be enough to deter banks from seeking lower rates. They might do so in either private markets or by tapping government-backed agencies like Fannie Mae and Freddie Mac, which are not allowed to receive interest on reserves, allowing them to sell mortgage-backed securities to investors at very low rates.