The Dow Jones Industrial Average reached a milestone on July 19, closing at 14,000 after touching—then retracing—the historical mark in intraday trading earlier in the week. Although stocks retreated shortly thereafter, the equity bulls have been doubling-down their bets all month, gulping-up shares like a whale in a school of plankton. Meanwhile, continued downgrades of collateralized debt obligations (CDOs) backed by subprime mortgage collateral and the collapse of two Bear Stearns hedge funds irked bond market investors, sending them scrambling to the safety of Treasuries and forcing the yield on the bellwether 10-year note, which had been trading as high as 5.295% as recently as last month, down to 4.95% on July 20.

The driving force behind the stock market’s recent rally has been corporate America’s impressive ability to consistently wring profits out of the economy, despite concerns of regional housing weakness. Other factors behind the Dow’s growth:

• Companies deploying excess cash to share buybacks—and giving their investors immediate gratification—in lieu of investing capital in long-term and infrastructure expansion (one of the reasons the manufacturing sector continues to lag).
• The continued robust pace of private equity buyouts. Rather than a response to any fundamental economic weakness, the recent rally in the U.S. Treasury market (which is unusual in that stocks and bonds rarely move in the same direction) has been more event-driven as investors move out of riskier mortgage bonds and corporate debt into higher quality products. The significant widening of credit default swaps (CDS), which reflects higher costs to purchase credit protection on corporate bonds, bank loans, and CDOs, vividly depicts this trend.

On the economic data front, in his semi-annual testimony before both houses of Congress, Federal Reserve Board Chairman Ben Bernanke asserted that economic growth will pick-up next year and that inflation, which remains the predominant Fed policy concern, will recede. The market interpreted Chairman Bernanke’s remarks to suggest that the Federal Open Market Committee (FOMC), which is the policy-making arm of the Fed, is highly unlikely to cut rates anytime soon. Although the market continues to price-in a modest chance for a rate cut by early next year, this conclusion was bolstered by the economic data, as we considered two of the government’s three inflation gauges.

According to the Labor Department, both wholesale and retail prices in June were stable. The headline Producer Price index (PPI), which gauges wholesale inflation, fell 0.2%, while the core PPI, which excludes volatile food and energy costs, rose 0.3%. The 0.2 % drop in the headline PPI, which followed a 0.9% increase in May, added to evidence that the economy is growing at a modest clip without a surge in inflation.

The second inflation measuring tool recently released was the Consumer Price Index (CPI), which broadly measures retail inflation prices. Both headline and core consumer prices rose 0.2% in June, the smallest gain in five months, led by declines in gasoline prices. The modest increase in consumer prices follows a 0.7% jump in May, again lending to the belief inflation is contained—at least for the moment.

The third (and Fed preferred) measure of inflation is the core Personal Consumption Expenditures (PCE) deflator, which will be released by the Commerce Department on July 31. In May, the PCE deflator rose 0.1%, and the latest consensus forecast is for a 0.2% increase for June. The year-over-year PCE for May was 1.9%, which is at the upper range of the Fed’s 1 to 2% “comfort zone.”

Since consumer spending accounts for approximately 70% of the overall economy, the CPI has traditionally been the “alpha” inflation gauge; however, the use of the PCE deflator, which tracks the amount of money spent on goods and services and became more prevalent under former Fed Chairman Alan Greenspan, is widely regarded as the most accurate dynamic inflation measuring stick. Experts argue that the PCE deflator is superior to the CPI because it more accurately tracks changes in consumer spending habits as prices of goods and services vacillate. While the CPI tracks a fixed basket of goods and services, the PCE deflator tracks a variable basket, and finds the average increase in prices for all domestic personal consumption.

Turning to other markets, the dollar—which has continued to trail rivals—recently fell to a record low versus the euro on concern that the subprime debacle could trigger a domestic economic slowdown. The yen also gained some ground on the dollar as investors repurchased the Japanese currency to unwind the so-called “carry trade” in which they borrow in yen to take advantage of Japan’s ultra-low, short-term rates and then invest in higher-yielding assets denominated in foreign currencies. In commodities, crude oil for August delivery climbed to a recent high of $76 a barrel.

Looking ahead, we will be receiving a bevy of economic data that should shine some light on a range of sectors, including housing and employment. The market will continue to watch equities to see if the Dow can hold its new lofty highs, as well as the CDO and mortgage markets for continued signs of stress. Recent debt market woes and credit spread widening could imperil the tenuous upside hold stocks have as the buyout specialists are finding it more difficult to place the massive amounts of debt and bank loans needed to fund their takeover deals. The employment picture remains solid, but at a steady 4.5% jobless rate, economists and market participants will be watching the numbers for signs of wage pressure spilling into the picture, which could raise the specter of inflation. On the flipside, a continued drop in Treasury yields could trigger a small wave of mortgage refinancing, which would force some convexity rebalancing by originators and servicers who hold the bulk of interest rate exposure, placing more downward pressure on interest rates and interest rate swap spreads.

By Jonathan Hartley, Institutional Sales and Trading Manager at the Federal Home Loan Bank of Seattle.

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