We are seeing more evidence that the worst of the credit crisis is behind us. May non-farm payrolls were down “only” 345,000, when a 530,000 decline had been expected. This is in keeping with mantra of the bulls that the “less bad is now the new good." There is no argument that a drop in nonfarm payroll numbers of any magnitude is not friendly for the economy. Relatively speaking however, when compared to the string of 500,000 plus nonfarm payroll declines, down  only 345,000 is a huge improvement and the market took notice.
 
Within a very short period of time from when the employment numbers were released, stock index futures quickly rallied and the credit markets precipitously fell. The bearish surprise jump in the nation’s unemployment rate to 9.4%, when 9.2% was anticipated, was ignored by the credit markets and the stock index futures market as traders centered on the more important nonfarm payroll portion of the report.

Although many of the recent economic reports have continued to show economic weakness, the rate of decline of most of these reports appears to be slowing. While more of the most recent economic reports on the economy continue to show decline, there have been some reports that actually have been much better than the analyst’s expectations. One example of this was the surprisingly better than expected April personal spending report, which showed a .5% increase against an estimate of a .2% decline. Other examples are the May Institute for Supply Management Index, which was 42.8 when 42 was anticipated and the April construction spending report, which shocked traders by showing a .8% increase. The mean estimate for this report called for a 1.5% drop.   These are just a few of the  “green shoots”  of hope for an economic recovery that  Federal Reserve Board Chairman Bernanke first referred to when last March he told the “60 Minutes” television program that he detected “green shoots” of economic recovery. 

We are seeing more signs that the worst of the economic decline has passed and it now looks as though the multitude of stimulus packages and bailout plans have been sufficient to offset the destruction of wealth that has taken place as a result of the subprime mortgage related write downs. It appears that the simulative efforts undertaken by the Federal Reserve and the Treasury Department may cause the downturn in the economy to be of a shorter duration than it normally would have been.  The combined impact of all the world’s interest rate cuts and stimulus packages is beginning to have the desired effect. 
  

The recent upward pressure on short term interest rates is not as bearish as it first appears.  In fact, at this stage it is actually a bullish indication for stock index futures, because higher short term interest rates are often associated with a firming economy. It appears hard to believe, but because short term interest rate have increased so much in the past week, there is now a chance that the Federal Reserve will increase interest rates by the end of the year, according to the financial futures markets. Specifically, there is a 58% probability that the Federal Open Market Committee will increase their fed funds target to 50 basis points by their November 4th meeting. Our own analysis suggests that a rate increase from the Federal Reserve this year is very unlikely. However, there could be one later next year, especially if we are correct in our thinking that we are on the road to economic recovery. The vast majority of the primary government securities dealers also believe that there will not be an interest rate increase from the Federal Open Market Committee this year and that the financial futures markets are incorrectly pricing in such a high probability of a rate increase. However, we do believe that higher free market short term interest rates at this part of the economic cycle should be viewed as one of the best indications that there will be increased loan demand in an environment of economic recovery. We can expect a strengthening economy this year and next year in conjunction with better stock index futures prices.  This anticipated economic recovery, along with higher stock index futures is likely to be a multiyear event.

If you have any questions or comments about this article, please contact Alan at 1.800.243.2649 or email him at alan.bush@archerfinancials.com.

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