Fed to Keep Doing the Twist, Stocks Twirl Around Flatline

Fed to Keep Doing the Twist, Stocks Twirl Around Flatline

US stocks finished modestly lower today, as the release of the Federal Reserve's monetary policy decision and subsequent press conference resulted in an afternoon of choppy and cautious trading. The Fed made no changes to interest rates, but did vote to extend its maturity extension program, known as "Operation Twist," through the end of the year. Additionally, Fed Chairman Ben Bernanke said the Committee is "prepared to do more" if needed, amid a downgrade in its growth and unemployment rate forecasts, and as Fed officials took a slightly more dovish stance in their interest rate assessments. Treasuries were mixed, as the domestic economic docket also included a slight drop in mortgage applications. Crude oil prices moved sharply lower, while gold prices also lost ground. In equity news, Dow member Procter & Gamble Co lowered its 4Q earnings outlook, while Adobe Systems Inc narrowly bested the Street's profit projection, but offered disappointing guidance.

The Dow Jones Industrial Average (DJIA) fell 13 points (0.1%) to 12,824, the S&P 500 Index declined 2 points (0.2%) to 1,356, and the Nasdaq Composite was flat at 2,930. In moderate volume, 735 million shares were traded on the NYSE and 1.5 billion shares changed hands on the Nasdaq. WTI crude oil declined $2.28 to $81.75 per barrel, Brent crude oil declined $3.18 to $92.58 per barrel, wholesale gasoline lost $0.05 to $2.59 per gallon, and the Bloomberg gold spot price fell $11.51 to $1,606.88 per ounce. Elsewhere, the Dollar Index—a comparison of the US dollar to six major world currencies— was 0.1% higher at 81.50.

Dow member Procter & Gamble Co. (PG $60) lowered its fiscal 4Q and full-year profit outlooks, primarily driven by slower-than-anticipated revenue growth from smaller-than-projected market growth, market share softness in developed regions, and negative impacts from foreign exchange rate changes. PG traded solidly lower.

Adobe Systems Inc. (ADBE $32) reported 2Q EPS ex-items of $0.60, one penny above the consensus estimate of analysts surveyed by Reuters, as revenues rose 10% year-over-year (y/y) to $1.1 billion, roughly inline with the Street's expectations. The software company issued 3Q guidance with the midpoint of its range coming in below analysts' forecasts, as well as reduced its full-year revenue outlook. Shares were under heavy pressure.

Fed extends operation twist through the end of the year, lowers growth forecasts

The statement from the two-day Federal Open Market Committee (FOMC) meeting was released, wherein the Fed left the fed funds rate unchanged near zero, while reiterating its broad characterization of economic growth as "the economy has been expanding moderately this year." However, the Fed noted that "growth in employment has slowed in recent months," while maintaining that the unemployment rate remains elevated. Moreover, the Central Bank noted that business fixed investment has continued to advance, but "household spending appears to be rising at a somewhat slower pace than earlier this year." Additionally, the Fed reiterated that despite some improvement, the housing sector remains depressed, while pointing out that inflation has declined, due mostly to the drop in crude oil and gasoline.

The Fed also maintained that conditions are likely to warrant an exceptionally low level for the fed funds rate at least through late-2014. Additionally, the FOMC decided to extend its Maturity Extension Program, dubbed "Operation Twist," or the Fed’s policy to reinvest principal payments from holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. Operation Twist was slated to end at the end of the month, but has now been extended to through the end of the year. Moreover, the FOMC left the door open for more stimulus measures, noting that it is "prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability."

The lone dissenter at this meeting was Jeffery Lacker for a third time, who opposed the continuation of Operation Twist.

In the post-statement news conference and Q&A session, Fed Chair Ben Bernanke further acknowledged that the Committee is "prepared to do more" to strengthen the economy, but added that "we have to get additional information on the state of the economy, what's happening in Europe." He further warned that there is a cost associated with easing programs and they can’t be taken lightly. The Fed also published individual policymakers’ forecasts for the federal funds rate, in an effort to promote greater transparency. The rate assessments showed a slightly more dovish committee, with three officials seeing a rate increase this year, three expecting an increase in 2013, seven predicting the first hike to occur in 2014, and six seeing the Fed holding off until 2015. The numbers were skewed somewhat by the confirmation of two new Fed governors in May, which increased the total number of officials to 19 from 17.

Meanwhile, the Fed’s economic projections reflected weaker growth, higher unemployment, and slightly softer inflation over the next few years. Specifically, GDP growth in 2012 was revised 0.5% lower from April estimates, while the 2013 and 2014 growth rates also received a downward revision. Additionally, 2012 unemployment rate forecasts came in at 8.0%-8.2%, up from the 7.8%-8.0% estimate provided in April, while the 2013 and 2014 rates were also increased. Finally, core PCE inflation projections were mostly unrevised from the April projections, although the ranges for 2012 and 2014 were slightly wider.

Treasuries were mixed, as the extension of Operation Twist lifted yields on the short end of the curve, while putting downward pressure on long-term rates. The yield on the 2-year note gained 1 basis point (bp) to 0.31%, the yield on the 10-year note increased 3 bps to 1.65%, while the 30-year bond rate declined 2 bps to 2.72%.

In other economic news, the MBA Mortgage Application Index decreased by 0.8% last week, after the index that can be quite volatile on a week-to-week basis grew 18.0% in the previous week. The decline came as a 1.0% increase in the Refinance Index was more than offset by an 8.5% drop in the Purchase Index. The slowdown in mortgage applications came even as the average 30-year mortgage rate declined 1 bp to 3.87%.

Europe mostly higher in cautions pre-Fed action

The equity markets in Europe finished mostly higher, extending yesterday's steep advance in the region on growing expectations that global central banks will deploy further measures to try to stoke economic growth and help the eurozone combat its festering debt crisis. Meanwhile, Greece announced a coalition government, which eased concerns about the troubled nation's political uncertainty and its future as a eurozone member. Elsewhere, the minutes from the Bank of England's (BoE) most recent policy meeting showed that four out of the nine voting BoE members called for more asset purchases by the central bank, including Governor Mervyn King. The sign that the momentum is growing for more asset purchases from the BoE comes as the UK last week announced a new "funding for lending" scheme amounting to about 80 billion pounds ($126 billion), added to the hopes for global central bank stimulus measures.

In the lone economic release from the Asia/Pacific region, Japan's trade deficit came in wider than expected for May, with imports rising at a much higher rate than projected.

Reads on the US housing and job markets on the docket

The economic calendar tomorrow includes existing home sales, expected to fall 1.1% m/m in May to an annual rate of 4.57 million units, after gaining 3.4% in April to 4.62 million units. Sales of existing homes reflect closings from contracts entered one-to-two months earlier. The housing market appears to be recovering when looking at the broader trend excluding month-to-month volatility. The homebuilder sentiment index reported this week rose to 29, the highest level since May 2007 and the National Association of Realtors in last month’s existing home sales report said it is no longer just investors taking advantage of high affordability conditions. However, as the Fed said today, the housing market remains depressed and Fed Chair Bernanke added that “mortgage access has been more restricted,” and that “we’re not getting the size of the boost we would normally get” in a housing recovery.

The job market is an additional area of concern for the Fed and among the reasons cited in today’s extension of Operation Twist. The recent upward trend in initial jobless claims has given market watchers pause due to its leading nature, and tomorrow’s report is forecasted to fall to 383,000 after rising 6,000 the week before to 386,000. As Schwab’s Chief Investment Strategist Liz Ann Sonders, Director of Market and Sector Analysis Brad Sorensen, CFA, and Director of International Research Michelle Gibley, CFA note in the latest Schwab Market Perspective: Time for Action, confidence about the economic expansion is waning, with anemic 1Q gross domestic product of 1.9% a sign that we’re close to the “stall speed” for the economy, where the possibility of returning to recession increases. While the Fed has shown a willingness to take action, we remain skeptical about the impact of Fed action, other than perhaps psychological. As Bernanke said in his recent Congressional testimony, further action may have “diminishing returns.” We believe a renewed sustainable uptrend in the stock market may be hard to come by until some substantive policy actions are taken around the globe, likely keeping markets volatile. Read more at www.schwab.com/marketinsight.

Other US reports tomorrow include the Philly Fed Manufacturing Index, expected to increase to zero from -5.8, and leading indicators, expected to gain 0.1% in May. International economic reports include preliminary June reads on Chinese manufacturing and PMI manufacturing and services reports across Europe, Japanese machine tool orders, and retail sales in the UK and Canada.

Schwab Center For Financial Research
Market Analysis Group

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