The Federal Reserve delivered a quarter-point cut in interest rates as expected on Wednesday, but wild swings in major stock indexes after the announcement showed that investors are struggling to understand whether the Fed's accompanying remarks suggest the central bank may be finished with pre-emptive moves to head off a slowdown in the U.S. economy.
Major U.S. stock indexes quickly reversed to the downside before rebounding to levels higher than before the Fed's announcement, as investors wrestled with whether or not the Fed can be counted on for further monetary easing in the near future. The initial negative reaction to the Fed's statement reveals the market's concerns that the knock-on effects of the housing slump and credit crunch haven't run their course. That would seem to reduce the significance of initial data showing U.S. gross domestic product grew faster than expected in the third quarter.
On Wednesday, the Dow Jones industrial average finished 137.54 points, or 1.00%, higher at 13,930.01. The broader S&P 500 index advanced 18.36 points, or 1.20% to 1,549.38. The tech-heavy Nasdaq composite index rose 42.41 points, or 1.51%, to 2,859.12.
On the New York Stock Exchange, 24 stocks traded higher for every nine that lost ground, while breadth on the Nasdaq was 20 to 11 positive. The big winners of the day were basic materials stocks such as Newmont Mining (NEM) and technology manufacturers, which stand to gain the most from a weaker dollar, given their exposure to export markets.
The Federal Reserve's policy committee cut the Fed funds rate by 25 basis points to 4.50% and also eased the discount rate by 25 basis points to 5.0%, to forestall further disruptions in the broader economy. But by saying that it now sees the inflation risk balancing the downside risk to economic and will be carefully monitoring inflation going forward, the Fed signaled it was not inclined to cut rates further until it sees data clearly showing that effects from the housing and financial sectors are spreading to the broader economy.
The key data points Ben Bernanke & Co. will be watching between now and the next policy committee meeting on Dec. 11: anything reflective of consumer spending, such as retail sales reports, and business spending, said Diane Dercher, chief economist at Waddell & Reed in Overland Park, Kans.
"Those will show us how tighter credit is influencing spending behavior, both on the consumer and business sides," she said.
Dercher said she expects consumer numbers to soften heading into next year, as people tighten their purse strings in response to higher energy prices, further deterioration in home equity and slowing income growth as unemployment starts to rise. A lot of mortgage rate resets lie ahead and high inventories in the housing market continue to weigh on home prices, she said.
"I don't think the Fed's out of the game yet in terms of not being there to lower rates," she said. "But they’re now wanting to see more evidence that there's an impact on the economy and data."
Advance GDP growth came in at 3.9%, ahead of economists' 3.1% forecast, and slightly better than the 3.8% growth seen in the second quarter. Consumption was up a "still robust" 3% while exports boomed, up 16.2%, Action Economics notes. Residential construction plummeted 20.1%. The initial GDP data suggest an economy that is growing faster than many expect, and that has less of a chance of being pushed into recession by housing's slowdown or the aftermath of the summer's financial crisis.
Back-to-back GDP gains of nearly 4.0% for the past two quarters show "the economy is incredibly resilient" in the face of the credit problems that rocked the markets in August, Edward Lazear, Chairman of the Council of Economic Advisors, said on CNBC. The impact of rising oil prices was mitigated by a strong labor market and, most importantly, by particularly strong growth in U.S. exports, which has been aided by expansion in the global economy, he said.
However, "while the economy statistically looks very good, it feels much worse than the numbers indicate,"
writes Ken Kim of Stone & McCarthy Research Associates. "The headwinds the economy faces grew stronger in the third quarter and show no signs of abating anytime soon. The economy continues to be supported by solid consumer spending and booming exports, but we wonder how much longer the consumer can continue to carry the load." Expect slower growth in the next few quarters, showing weakness in residential investment and slower consumer spending, he says.
There's a notable contrast between the GDP growth over the past two quarters and the pessimistic economic descriptions that dominate market discourse and the Fed's policy debate, Action Economics said.
But some analysts are saying the Fed made a mistake by highlighting higher inflation risks, given that rising oil prices are being driven by geopolitical instability, not supply shocks that would swell business input costs and slow economic growth.
Aside from the fact that the core PCE deflator has been within the Fed's comfort zone of 1.5% to 2.0% for the past three months, what gives the Fed cover for another rate cut are the housing recession and ongoing spasms from this summer's credit crunch, both of which are "unambiguously deflationary," says Max Bublitz, chief strategist at SCM Advisors LLC in San Francisco.
He describes the Fed moves to cut interest rates as reflationary in nature, designed to counter a deflationary trend.
He said as long as the Fed funds rate will limit growth as long as it remains notably above the pace of nominal GDP growth between 3.5% and 4.0%. The U.S. economy isn't and hasn't been functioning at or near its potential, and won't until the Fed funds rate reaches a more neutral level around 4.0%, he said. Given that, the Fed probably has the scope and cover to continue cutting rates in the future, he added.
On Wednesday, oil traders all but forgot the $3 per barrel retreat in oil prices on Tuesday. Crude oil for December delivery in New York soared $4.15 to close at $94.53 per barrel after a surprise 3.9 million barrel drop in crude inventories for the week ending Oct. 26, as reported by the U.S. Energy Information Administration. The market had anticipated a crude supplies would increase by 100,000 to 600,000 barrels. This is the second week in a row that crude supplies have fallen unexpectedly. Gasoline stocks rose 1.3 million barrels, while distillates climbed by 800,000 barrels. Further weakening in the dollar on the back of the Fed rate cut likely gave prices an added boost.
In other economic news, a report showed U.S. employment costs rose 0.8% in the third quarter, much as expected, after a 0.9% increase in the second quarter. The ADR National Employment Report showed a 106,000 rise in nonfarm private payrolls from September to October of 2007 on a seasonally adjusted basis, after an upwardly revised 61,000 gain from August to September. A 134,000 surge in service-related jobs was partly offset by further declines in the goods-producing and manufacturing sectors.
The Chicago Purchasing Managers index of industrial activity fell to 49.7 in October from 54. 2 in September, led by a big decline in shipments and further moderation in orders and employment. Prices paid surged to 74.7 from 59.0 thanks to a jump in oil prices to new all-time highs. The data imply a weak start to the fourth quarter after the rebound in the index in the second quarter, Action Economics said.
U.S. construction spending recovered 0.3% in September but after a downwardly revised 0.2% decline in August. Residential construction slipped 1.4% and is down 16.4% on the year, which isn't surprising given the 20.1% dropoff shown in the third-quarter GDP report, Action Economics said. Nonresidential construction rose 1.8% and is up 16.7% from a year ago.
Among stocks in the news Wednesday, Google (GOOG) shares topped $700 after The Wall Street Journal reported that the company is talking with Verizon Wireless (VZ) and Sprint ( Next Page
com/ticker/' rel='ticker'>S) about offering handsets tailored to Google's new operating system.
Penn West Energy Trust (PWE) plans to buy Canetic Resources Trust (CNE), offering 0.515 Penn West shares for each Canetic share in a $3.8 billion deal. Penn West shares fell 1.0% while Canetic shares gained 4.7%.
MasterCard (MA) shares surged 20.9% after it reported a 63% surge in third-quarter profit to $2.31 a share from $1.42 a share in the prior-year period on a 20% rise in net revenue. The latest results included an after-tax gain of 51 cents a share from the partial sale of MasterCard's stake in Redecard SA, a company that signs up merchants in Brazil. The credit card company set a $750 million stock buyback.
Silicon Motion Technology Group (SIMO) shares jumped 15.2% after it posted third-quarter GAAP earnings of 30 cents a share, vs. 28 cents a sgare a year ago on a 44% jump in revenue. The semiconductor maker expects fourth-quarter revenue to rise 40% to 46% from the prior-year period.
Chipotle Mexican Grill (CMG) shares gained 4.1% on news that same-restaurant sales in 12% the third quarter, as revenues were up 36%. The chain posted earnings of 62 cents per share, vs. 36 cents a year ago.
Private equity firm Cerberus Capital Management officially withdrew its $6.2 billion offer for Affiliated Computer Services (ACS) on Tuesday after shareholder resistance to the deal, according to a report in the Wall Street Journal.
Garmin Ltd. (GRMN) shares fell 10.9% despite a gain in earnings to 88 cents in the third quarter from 56 cents a year ago, on a 79% leap in revenue. The maker of global positioning system technology expects narrower profit margins in the fourth quarter.
European equity indexes were up on Wednesday. In London, the FTSE 100 index gained 0.94% to trade at 6,721.60. Germany's DAX index rose 0.52% to 8,019.22. In Paris, the CAC 40 was up 0.76% at 5,847.95.
Asian markets were mixed. In Japan, the Nikkei 225 index finished 0.52% higher at 16,737.63. In Hong Kong, the Hang Seng index fell 0.9% to 31,352.58. The Shanghai composite index rose 0.98% to 5,954.76.
Treasury prices dropped after the Fed announcement. The two-year note was off 08/32 to 99-12/32 for a yield of 3.94%; the 10-year notes fell 22/32 to 102-06/32 for a yield of 4.47%; and the 30-year bond dropped 1-03/32 to 104-02/32 for a yield of 4.74%.