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Odds of rate cuts, then rate hikes, dance around on slew of economic news
By Laura Mandaro, MarketWatch
Last update: 5:05 p.m. EST Feb. 26, 2008
SAN FRANCISCO (MarketWatch) -- Inflation worries Tuesday roiled segments of the financial markets that predict how high inflation will go, and what the Fed will do about it.
In the futures markets, odds fell to 88% that the Federal Reserve will cut interest rates by 50 basis points to 2.5%, when it meets March 18. The drop followed the Labor Department's report on wholesale inflation, which jumped more than economists had generally anticipated. The rise reflected higher energy, food, drug and car prices, and compounded concerns that slowing U.S. growth isn't cooling inflation.
"It's a combination of inflation numbers and economic data, which while weaker, has been a little mixed," said John Canavan, analyst at economic research firm Stone & McCarthy, about the drop in rate-cut views, which have eased after peaking earlier this month.
Surprise bursts of inflation generally dampen forecasts for Fed rate cuts because they are seen curbing the Fed's ability to engineer looser credit conditions. Federal Reserve policy makers frequently note the importance of keeping inflation expectations, in addition to actual inflation, at bay.
In the bond market, fretting about inflation translated to big moves in a security whose payout is tied to consumer inflation readings. The yield spread between 10-year Treasury Inflation Protected Securities, and conventional 10-year Treasuries, jumped 7 basis points Tuesday to 2.46%, its highest level in eight months.
What's known as the TIPS spread had remained in a 2.30% to 2.4% range for several months, despite higher inflation readings.
On the flip side, fresh signs of economic gloom generally serve to dampen inflation expectations and raise forecasts for rate cuts.
After the Conference Board released its mid-morning survey on consumer sentiment, the implied odds for a March 18 rate cut bounced back to 96%, as priced in the April fed funds contract. The report showed consumer confidence drooping to a nearly 15-year low, excluding the start to the 2003 Iraq War. Consumer expectations dropped to a 17-year low.
Raising rates
Further in the future, traders adjusted their views on when the Fed will start raising rates next year. The implied fed funds target rate priced in Eurodollar contracts for March 2009 rose after the inflation report came out and then slipped after the Conference Board reading.
"These contracts indicate the market expects rate hikes next year," said Tony Crescenzi, chief bond market strategist at Miller Tabak & Co. "That view was fortified after the PPI," he said, but then withered after consumer sentiment results.
Moves in inflation, and how the market reacts, are sure to weigh on Fed decisions ahead of their March meeting. In minutes from the Fed's late January meeting, and in comments, policymakers generally have emphasized the risk to growth is overshadowing inflation threats.
"I do not expect the recent elevated inflation rates to persist," said Donald Kohn, vice chairman of the Federal Reserve Board, in a speech prepared for delivery Tuesday.
Commentary: Europe's economy is doing okay, but public isn't happy
By MarketWatch
Last update: 10:43 a.m. EST Feb. 26, 2008
LONDON (MarketWatch) - There's an odd disconnect between German public sentiment toward the business world and how Europe's largest economy actually is functioning.
Looking at data released on Tuesday by the Ifo Institute or the continued drop in unemployment, and it appears the German economy is humming along fairly well, no matter what the worries about a possible U.S. recession, the strong euro or corporate corruption.
There of course is the risk that the data is off base, but the 7,000 firm Ifo survey has history on its side, judging by its close correlation to German GDP. And other data, such as a recent poll of purchasing managers, also shows that the German economy is doing fairly well.
And yet the German public isn't dancing in the streets. Angela Merkel's Christian Democratic Union has been faltering in recent regional elections, and politicians are more apt to complain about job-cut plans at Nokia (NOK:) than sing the praises of Deutschland AG.
The reaction to the Siemens job cut plan announced Tuesday so far has been muted, but if as rumored it partners with Cerberus Capital, any further job cuts at the enterprise communications unit are likely to fire up the "locust" brigade. See related story.
Merkel herself is no innocent in this matter. For whatever the merits of bribing a foreign national to get information to crack down on tax evasion, such a maneuver is going to whip up hostility toward the business world. See related Liechtenstein story.
And Merkel has publicly criticized Nokia's job cut plans, as if the Finnish company has some public-service obligation to make unprofitable mobile phones in the country, something even home-town Siemens couldn't stomach.
Once the anti-corporate fire is ignited, Merkel will find it will be difficult to douse -- and that it may burn her as well.
By Steve Goldstein, MarketWatch
Last update: 5:57 a.m. EST Feb. 27, 2008
LONDON (MarketWatch) - U.S. stock futures on Wednesday pointed to some profit-taking as Federal Reserve Chairman Ben Bernanke heads to Congress with the U.S. dollar plumbing record lows against rivals.
S&P 500 futures fell 3.6 points to 1,379.20 and Nasdaq 100 futures edged 4 points lower to 1,792.75. Dow industrial futures slipped 25 points.
A $15 billion stock buyback plan from International Business Machines helped trigger the second-straight surge in U.S. stocks on Tuesday, with the Dow industrials rising 114 points, the S&P 500 gaining 9 points and the Nasdaq Composite rising 0.8%.
Eyes will be trained on Washington D.C. on Wednesday as Bernanke begins his two days of testimony, starting at 10 a.m. Eastern.
Vice Chairman Donald Kohn on Tuesday said that, despite signs that inflation actually strengthened in January, the nation's weak economy and fragile financial markets remain a bigger threat than higher prices. Kohn's views are generally thought to be closely aligned with Bernanke's.
There's also data due on durable-goods orders and new-home sales for January, as well as weekly energy inventories statistics.
Before the latest data and speeches, markets were seeing the U.S. dollar trading around record lows, and gold and oil futures trading around record highs.
The euro broke through the $1.50 level for the first time ever late on Tuesday, and was trading up 0.4% at $1.5064. The greenback also fell against other rivals.
Oil futures rose 40 cents to $101.28 a barrel and gold futures rose $12.60 to $961.50 an ounce.
Yields on 10-year Treasury bonds fell to 3.81%.
There's also more earnings reports, including from Dynegy (DYN:) , Mylan Labs (MYL:) and after the close, from Limited Brands (LTD:) .
Amgen (AMGN:) and Johnson & Johnson (JNJ:) each lost 2% in Frankfurt after a study published late Tuesday in the Journal of the American Medical Association showed that treating anemia with erythropoiesis-stimulating agents increases the risk of certain blood clots and death among cancer patients.
Autodesk (ADSK:) may fall after the design software maker's virtually flat earnings came in below analyst estimates.
Microsoft (MSFT:) was fined 899 million euros ($1.35 billion) by the European Commission for failing to comply with its 2004 antitrust ruling. It brings the fines levied by the European Commission against Microsoft for alleged anti-competitive activity to 1.68 billion euros.
Luxury home builder Toll Brothers (TOL:) swung to a fiscal first-quarter loss of $96 million and said "ceaseless talk" about a recession is dampening the mood of consumers.
International markets were mixed. Asian stocks generally rose, led by a 3.1% advance from the Hang Seng after a Hong Kong tax break package, while stocks in Europe were lower, with the FTSE 100 losing 0.6% in London.
Currency cracks through stubborn resistance, interest rate view a factor
By William L. Watts, MarketWatch
Last update: 5:57 a.m. EST Feb. 27, 2008
LONDON (MarketWatch) -- The euro remained above the $1.50 level Wednesday morning after notching a new all-time record high against the dollar on fears the U.S. economy may be flirting with stagflation -- a combination of stagnant growth and high inflation.
The dollar's plunge to a new low "was unexpected, but nevertheless a risk that could happen if the right circumstances were at the same place at the same time," wrote currency analysts at Jyske Bank.
Those circumstances came together Tuesday, with a stronger-than-expected reading from Germany's Ifo business-climate index, a weaker-than-expected U.S. consumer-confidence report and dovish remarks from U.S. Federal Reserve Vice Chairman Donald Kohn, the analysts noted.
Despite signs that inflation strengthened in January, the weak U.S. economy and fragile financial markets remain a bigger threat than higher prices, Kohn said in a speech. Read about Kohn.
The euro broke through $1.4966 -- the previous all-time high against the dollar set on Nov. 23 -- in North American trading Tuesday. That break through the old high, which had provided stubborn resistance in previous euro rallies, triggered strong technical buying, analysts said.
The euro went on to breach $1.50 in late North American and early Asian trading. It then further extended gains Wednesday morning, breaking through further resistance at $1.5050 to notch another high at $1.5087, according to data from FactSet. The euro was seen changing hands near $1.5055 in recent activity.
The single European currency, which now covers 15 nations, began trading in January 1999.
The dollar was weaker against all major currency partners Wednesday morning, falling 0.9% against the Japanese yen to 106.35 yen, declining 0.1% against the British pound to $1.9899, and slipping 0.4% against the Swiss franc to $1.0687. The U.S. unit was down 0.5% against the Australian dollar to $0.9386.
The euro's strength was seen contributing to pressure on European stocks. A stronger currency makes euro-zone exports more expensive for foreign buyers. See Europe Markets.
Rate expectations
Diverging interest-rate expectations between the U.S. and the euro zone were a major feature in the dollar's fall, analysts said.
An unexpected rise in the Ifo index led markets to moderate expectations for the European Central Bank to begin cutting interest rates, while U.S. data and Kohn's remarks indicated the Federal Reserve was willing to continue cutting rates to prevent a major slowdown, wrote analysts at KBC Bank. Read about Tuesday's Ifo data.
The key event Wednesday will be Federal Reserve Chairman Ben Bernanke's congressional testimony.
"One can only expect Bernanke to confirm Kohn's view on the economy and on the Fed strategy going forward," the KBC analysts wrote. "This shouldn't be that much of a big surprise for markets, but in the current environment this can hardly be seen as dollar supportive."
The Federal Reserve has slashed its key lending rate by 2.25 percentage points since September to 3%.
The European Central Bank has held its base lending rate steady. Bank officials have acknowledged that European economic risks are weighted to the downside, but have also highlighted near-term inflation pressures. They emphasize that their sole mandate is to preserve price stability.
Inflation worries
Meanwhile, worries that the Fed's strategy could fuel a spike in U.S. inflation are providing support for currencies backed by central banks that use inflation-targeting to set interest-rate policies, analysts said. See related story.
Currency markets appear "decidedly more fearful of the growing inflationary threat that the Fed's strategy appears to entail," wrote Neil Mellor, an analyst at Bank of New York Mellon. "Rising liquidity and growing pricing power is no bad thing for equity investors, but in the currency markets, nagging doubts over price stability have seen investors resume their focus upon currencies whose central banks are firmly in inflation-fighting mode."
The euro's strength is likely to spur further remarks from euro-zone politicians worried that exporters will be undercut, said Howard Archer, U.K. economist at Global Insight.
But with little appetite seen for coordinated currency market intervention, there is likely little that officials can do to dampen further euro gains, he said. Global Insight sees room for the euro to test $1.55 over the first half of 2008.
While the strong euro hurts euro-zone exporters by making their products more expensive to foreign buyers, it also makes imports cheaper -- a factor that should help moderate inflation pressures and may eventually give the ECB room to cut interest rates, Archer said.
Next stop
Technical analysts said the euro's break through the previous all-time high sets the stage for further gains, but cautioned that some near-term consolidation may be in the offing.
The euro's break through $1.5050 could set up a shot at $1.5250, wrote analysts at Mizuho Corporate Bank.
Analysis: Bernanke pushes Fed as far as possible on formal goal
By Rex Nutting, MarketWatch
Last update: 10:28 a.m. EST Feb. 27, 2008
WASHINGTON (MarketWatch) - After years of speculation and guessing, at last we know what the Federal Reserve's inflation target is: 1.5% to 2% core inflation over a three-year time horizon and just a little lower over the longer term
Pressured by criticism that it's getting soft on inflation as it slashes interest rates to boost growth, the Federal Open Market Committee set the informal inflation target to bolster its inflation-fighting credibility and to help anchor inflationary expectations.
Based on earlier comments from Chairman Ben Bernanke and others, Fed watchers have been assuming that the Fed had adopted an informal target of about 1% to 2% for core inflation.
The new target wasn't announced with any fanfare. It was slipped into a passage in the FOMC's semiannual report to lawmakers on Wednesday.
Fed Chairman Ben Bernanke, who has long advocated a formal inflation target for the Fed, has probably pushed resistant and skeptical committee members as far as they'll go.
Here's what the committee said in discussing its new economic projections:
"Projections for 2010 were importantly influenced by their judgments about the measured rates of inflation consistent with the Federal Reserve's dual mandate to promote maximum employment and price stability and about the time frame over which policy should aim to attain those rates."
Because monetary policy works with a lag, the growth and inflation rates projected for 2010 should be close to the rate policymakers are aiming for. In fact, however, the committee said the recent shocks to growth and inflation were so severe that it could take more time to achieve its longer-term goals.
The 1.5% to 2% inflation projection for 2010 "was judged likely still to be a bit above levels that some participants judged would be consistent" with the dual mandate.
Bernanke and his committee have been getting a lot of grief about ignoring surging inflation. Many investors think the Fed has abandoned its mandate to keep prices stable by overreacting to the economic slowdown. Inflationary expectations, as measured by the spread between regular Treasury notes and inflation-protected notes, have risen.
The FOMC counterattacked on Wednesday, saying that inflation is expected to "moderate significantly in 2008, as energy and food prices flatten out and pressures on resources diminish as the global economy cools.
And pointedly, the committee reminded the inflation hawks that the Fed has a "dual mandate" for growth AND inflation.
Still, upside risks to inflation persist. Food and energy prices could go higher, and global growth might not slow enough to ease pressures on key commodities.
If inflation does accelerate this year, that would be trouble.
"Any tendency of inflation expectations to become unmoored or for the Fed's inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and could reduce the flexibility of the FOMC to counter shortfalls in growth in the future," Bernanke said.
Bernanke signals Fed to stay on easing course
Acknowledges growing risk of inflation
By Greg Robb, MarketWatch
Last update: 10:22 a.m. EST Feb. 27, 2008
WASHINGTON (MarketWatch) -- Federal Reserve Chairman Ben Bernanke told Congress Wednesday that the central bank will remain on the course for additional rate cuts, at least in the near-term, although the journey has become more treacherous as prices are rising.
Downside risks to growth remain the key focus of monetary policy makers, he said.
The housing market downturn has spilled into the broader economy, causing financial markets to freeze, consumers to reduce spending and labor markets to soften, he noted. Fresh data since the last Fed meeting confirm a weak pace of growth.
"The incoming information since our January meeting continues to suggest sluggish economic activity in the near term," Bernanke said in his prepared testimony to the Senate Banking Committee.
The formal forecast of Fed officials remains for the economy to pick up in the second half of the year. The Fed has already cut its benchmark interest rates by 2.25 percentage points since the fall.
But looming just below the surface is worry at the Fed about a severe downturn spiral, where the weak financial market puts downward pressure on growth.
"The risks include the possibilities that the housing market or labor market may deteriorate more than is currently anticipated and that credit conditions may tighten substantially further," Bernanke said.
"The housing market is expected to continue to weigh on economic activity in coming quarters," he said, and financial markets "continue to be under considerable stress."
Homebuilders are likely to cut the pace of their activity further as inventories of unsold homes remain abnormally high, Bernanke said.
Commercial construction is likely to decelerate sharply in coming quarters as business activity slows and funding becomes harder to obtain.
On the bright side, Bernanke said at least the economy is not suffering from a serious overhang of business inventories. The nonfinancial business sector remains in good footing, he noted.
For Wall Street, a key point of Bernanke's testimony is that he did not attempt to alter market expectations that the Fed will choose to cut rates by an additional half a percentage point at its meeting on March 18.
"The FOMC will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks," Bernanke said.
But the testimony suggests that the Fed is making no pre-commitment on what it will do after the March meeting.
Coming on the heels of ugly inflation readings for January which showed rising prices, the Fed chairman acknowledges that the inflation risks have increased.
"Indeed, the further increases in the prices of energy and other commodities in recent weeks, together with the latest data on consumer prices, suggest slightly greater upside risks to the projections to both overall and core inflation than we saw last month," Bernanke said.
He stressed that the Fed would continue to monitor closely inflation and inflation expectations.
Inflation could be lower if slower-than-expected global growth reduces pressure on energy and food prices, he said.
But it could be higher if energy and food prices continue upward and spill over into core prices. Another factor is the weak dollar could boost import prices by a larger amount that the Fed expects.
A key point for the Fed going forward will be to judge whether the stimulus from the rate cuts, combined with the fiscal stimulus rushed through Congress, is working to limit the downside risks to growth.
"The FOMC will need to judge whether the policy actions taken thus far are having their intended effects," he said.
Even excluding aircraft, new orders fall across the board
By Rex Nutting, MarketWatch
Last update: 8:57 a.m. EST Feb. 27, 2008
WASHINGTON (MarketWatch) -- Demand for durable goods fell back in January after a burst of orders in December, the Commerce Department reported Wednesday, another sign that the economy is slowing.
New orders for durable goods fell 5.3% in January, close to the 5.1% drop anticipated by economists surveyed by MarketWatch.
December's gains were revised lower to 4.4% from 5% previously reported. The data are extremely volatile month-to-month.
Much of the decline in January was due to the unwinding of the flood of orders for aircraft in December. Declining demand was seen in almost every industry in January, however, despite reports of higher exports.
Excluding the 13.4% drop in transportation orders, orders for new durable goods fell 1.6%.
Orders for core capital equipment -- nondefense, nonaircraft capital goods -- fell 1.4% in January after a 5.2% rise in December.
Shipments of durable goods increased 1.8%, the biggest increase in six months after falling for two months. Shipments of core capital equipment goods -- which feed directly into calculations for business fixed investment in the gross domestic product figures -- rose 0.1%.
Economists are predicting no growth in GDP in the current quarter.
Inventories of unsold goods rose 0.6%, the sixth increase in the past seven months, a potentially troubling sign that goods are piling up on the loading docks.
Unfilled orders increased 0.6%, almost all in orders for civilian aircraft.
Details
Orders for transportation goods fell 13.4%, led by a 30.5% drop in civilian aircraft orders and a 32.6% drop in defense aircraft. Orders for motor vehicles fell 0.8%. Shipments of transportation goods rose 2.8%.
Orders for electronics (excluding semiconductors) fell 2.7%, including an 11.7% drop in orders for computers. Shipments of electronics (including semiconductors) rose 7.1%.
Orders for machinery fell 1.5%. Shipments fell 1.7%.
Orders for finished metals fell 4.1%. Orders for primary metals were unchanged.
Orders for electrical equipment rose 1.4%.
Semiannual Monetary Policy Report to the Congress
Before the Committee on Financial Services, U.S. House of Representatives
February 27, 2008
Chairman Frank, Ranking Member Bachus, and other members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. In my testimony this morning I will briefly review the economic situation and outlook, beginning with developments in real activity and inflation, then turn to monetary policy. I will conclude with a quick update on the Federal Reserve's recent actions to help protect consumers in their financial dealings.
The economic situation has become distinctly less favorable since the time of our July report. Strains in financial markets, which first became evident late last summer, have persisted; and pressures on bank capital and the continued poor functioning of markets for securitized credit have led to tighter credit conditions for many households and businesses. The growth of real gross domestic product (GDP) held up well through the third quarter despite the financial turmoil, but it has since slowed sharply. Labor market conditions have similarly softened, as job creation has slowed and the unemployment rate--at 4.9 percent in January--has moved up somewhat.
Many of the challenges now facing our economy stem from the continuing contraction of the U.S. housing market. In 2006, after a multiyear boom in residential construction and house prices, the housing market reversed course. Housing starts and sales of new homes are now less than half of their respective peaks, and house prices have flattened or declined in most areas. Changes in the availability of mortgage credit amplified the swings in the housing market. During the housing sector's expansion phase, increasingly lax lending standards, particularly in the subprime market, raised the effective demand for housing, pushing up prices and stimulating construction activity. As the housing market began to turn down, however, the slump in subprime mortgage originations, together with a more general tightening of credit conditions, has served to increase the severity of the downturn. Weaker house prices in turn have contributed to the deterioration in the performance of mortgage-related securities and reduced the availability of mortgage credit.
The housing market is expected to continue to weigh on economic activity in coming quarters. Homebuilders, still faced with abnormally high inventories of unsold homes, are likely to cut the pace of their building activity further, which will subtract from overall growth and reduce employment in residential construction and closely related industries.
Consumer spending continued to increase at a solid pace through much of the second half of 2007, despite the problems in the housing market, but it appears to have slowed significantly toward the end of the year. The jump in the price of imported energy, which eroded real incomes and wages, likely contributed to the slowdown in spending, as did the declines in household wealth associated with the weakness in house prices and equity prices. Slowing job creation is yet another potential drag on household spending, as gains in payroll employment averaged little more than 40,000 per month during the three months ending in January, compared with an average increase of almost 100,000 per month over the previous three months. However, the recently enacted fiscal stimulus package should provide some support for household spending during the second half of this year and into next year.
The business sector has also displayed signs of being affected by the difficulties in the housing and credit markets. Reflecting a downshift in the growth of final demand and tighter credit conditions for some firms, available indicators suggest that investment in equipment and software will be subdued during the first half of 2008. Likewise, after growing robustly through much of 2007, nonresidential construction is likely to decelerate sharply in coming quarters as business activity slows and funding becomes harder to obtain, especially for more speculative projects. On a more encouraging note, we see few signs of any serious imbalances in business inventories aside from the overhang of unsold homes. And, as a whole, the nonfinancial business sector remains in good financial condition, with strong profits, liquid balance sheets, and corporate leverage near historical lows.
In addition, the vigor of the global economy has offset some of the weakening of domestic demand. U.S. real exports of goods and services increased at an annual rate of about 11 percent in the second half of last year, boosted by continuing economic growth abroad and the lower foreign exchange value of the dollar. Strengthening exports, together with moderating imports, have in turn led to some improvement in the U.S. current account deficit, which likely narrowed in 2007 (on an annual basis) for the first time since 2001. Although recent indicators point to some slowing of foreign economic growth, U.S. exports should continue to expand at a healthy pace in coming quarters, providing some impetus to domestic economic activity and employment.
As I have mentioned, financial markets continue to be under considerable stress. Heightened investor concerns about the credit quality of mortgages, especially subprime mortgages with adjustable interest rates, triggered the financial turmoil. However, other factors, including a broader retrenchment in the willingness of investors to bear risk, difficulties in valuing complex or illiquid financial products, uncertainties about the exposures of major financial institutions to credit losses, and concerns about the weaker outlook for economic growth, have also roiled the financial markets in recent months. To help relieve the pressures in the market for interbank lending, the Federal Reserve--among other actions--recently introduced a term auction facility (TAF), through which prespecified amounts of discount window credit are auctioned to eligible borrowers, and we have been working with other central banks to address market strains that could hamper the achievement of our broader economic objectives. These efforts appear to have contributed to some improvement in short-term funding markets. We will continue to monitor financial developments closely.
As part of its ongoing commitment to improving the accountability and public understanding of monetary policy making, the Federal Open Market Committee (FOMC) recently increased the frequency and expanded the content of the economic projections made by Federal Reserve Board members and Reserve Bank presidents and released to the public. The latest economic projections, which were submitted in conjunction with the FOMC meeting at the end of January and which are based on each participant's assessment of appropriate monetary policy, show that real GDP was expected to grow only sluggishly in the next few quarters and that the unemployment rate was seen as likely to increase somewhat. In particular, the central tendency of the projections was for real GDP to grow between 1.3 percent and 2.0 percent in 2008, down from 2-1/2 percent to 2-3/4 percent projected in our report last July. FOMC participants' projections for the unemployment rate in the fourth quarter of 2008 have a central tendency of 5.2 percent to 5.3 percent, up from the level of about 4-3/4 percent projected last July for the same period. The downgrade in our projections for economic activity in 2008 since our report last July reflects the effects of the financial turmoil on real activity and a housing contraction that has been more severe than previously expected. By 2010, our most recent projections show output growth picking up to rates close to or a little above its longer-term trend and the unemployment rate edging lower; the improvement reflects the effects of policy stimulus and an anticipated moderation of the contraction in housing and the strains in financial and credit markets. The incoming information since our January meeting continues to suggest sluggish economic activity in the near term.
The risks to this outlook remain to the downside. The risks include the possibilities that the housing market or labor market may deteriorate more than is currently anticipated and that credit conditions may tighten substantially further.
Consumer price inflation has increased since our previous report, in substantial part because of the steep run-up in the price of oil. Last year, food prices also increased significantly, and the dollar depreciated. Reflecting these influences, the price index for personal consumption expenditures (PCE) increased 3.4 percent over the four quarters of 2007, up from 1.9 percent in 2006. Core price inflation--that is, inflation excluding food and energy prices--also firmed toward the end of the year. The higher recent readings likely reflected some pass-through of energy costs to the prices of core consumer goods and services as well as the effect of the depreciation of the dollar on import prices. Moreover, core inflation in the first half of 2007 was damped by a number of transitory factors--notably, unusually soft prices for apparel and for financial services--which subsequently reversed. For the year as a whole, however, core PCE prices increased 2.1 percent, down slightly from 2006.
The projections recently submitted by FOMC participants indicate that overall PCE inflation was expected to moderate significantly in 2008, to between 2.1 percent and 2.4 percent (the central tendency of the projections). A key assumption underlying those projections was that energy and food prices would begin to flatten out, as was implied by quotes on futures markets. In addition, diminishing pressure on resources is also consistent with the projected slowing in inflation. The central tendency of the projections for core PCE inflation in 2008, at 2.0 percent to 2.2 percent, was a bit higher than in our July report, largely because of some higher-than-expected recent readings on prices. Beyond 2008, both overall and core inflation were projected to edge lower, as participants expected inflation expectations to remain reasonably well-anchored and pressures on resource utilization to be muted. The inflation projections submitted by FOMC participants for 2010--which ranged from 1.5 percent to 2.0 percent for overall PCE inflation--were importantly influenced by participants' judgments about the measured rates of inflation consistent with the Federal Reserve's dual mandate and about the time frame over which policy should aim to attain those rates.
The rate of inflation that is actually realized will of course depend on a variety of factors. Inflation could be lower than we anticipate if slower-than-expected global growth moderates the pressure on the prices of energy and other commodities or if rates of domestic resource utilization fall more than we currently expect. Upside risks to the inflation projection are also present, however, including the possibilities that energy and food prices do not flatten out or that the pass-through to core prices from higher commodity prices and from the weaker dollar may be greater than we anticipate. Indeed, the further increases in the prices of energy and other commodities in recent weeks, together with the latest data on consumer prices, suggest slightly greater upside risks to the projections of both overall and core inflation than we saw last month. Should high rates of overall inflation persist, the possibility also exists that inflation expectations could become less well anchored. Any tendency of inflation expectations to become unmoored or for the Fed's inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and could reduce the flexibility of the FOMC to counter shortfalls in growth in the future. Accordingly, in the months ahead, the Federal Reserve will continue to monitor closely inflation and inflation expectations.
Let me turn now to the implications of these developments for monetary policy. The FOMC has responded aggressively to the weaker outlook for economic activity, having reduced its target for the federal funds rate by 225 basis points since last summer. As the Committee noted in its most recent post-meeting statement, the intent of those actions has been to help promote moderate growth over time and to mitigate the risks to economic activity.
A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of monetary policy is properly calibrated to foster our mandated objectives of maximum employment and price stability in an environment of downside risks to growth, stressed financial conditions, and inflation pressures. In particular, the FOMC will need to judge whether the policy actions taken thus far are having their intended effects. Monetary policy works with a lag. Therefore, our policy stance must be determined in light of the medium-term forecast for real activity and inflation as well as the risks to that forecast. Although the FOMC participants' economic projections envision an improving economic picture, it is important to recognize that downside risks to growth remain. The FOMC will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks.
Finally, I would like to say a few words about the Federal Reserve's recent actions to protect consumers in their financial transactions. In December, following up on a commitment I made at the time of our report last July, the Board issued for public comment a comprehensive set of new regulations to prohibit unfair or deceptive practices in the mortgage market, under the authority granted us by the Home Ownership and Equity Protection Act of 1994. The proposed rules would apply to all mortgage lenders and would establish lending standards to help ensure that consumers who seek mortgage credit receive loans whose terms are clearly disclosed and that can reasonably be expected to be repaid. Accordingly, the rules would prohibit lenders from engaging in a pattern or practice of making higher-priced mortgage loans without due regard to consumers' ability to make the scheduled payments. In each case, a lender making a higher-priced loan would have to use third-party documents to verify the income relied on to make the credit decision. For higher-priced loans, the proposed rules would require the lender to establish an escrow account for the payment of property taxes and homeowners' insurance and would prevent the use of prepayment penalties in circumstances where they might trap borrowers in unaffordable loans. In addition, for all mortgage loans, our proposal addresses misleading and deceptive advertising practices, requires borrowers and brokers to agree in advance on the maximum fee that the broker may receive, bans certain practices by servicers that harm borrowers, and prohibits coercion of appraisers by lenders. We expect substantial public comment on our proposal, and we will carefully consider all information and viewpoints while moving expeditiously to adopt final rules.
The effectiveness of the new regulations, however, will depend critically on strong enforcement. To that end, in conjunction with other federal and state agencies, we are conducting compliance reviews of a range of mortgage lenders, including nondepository lenders. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examinations of, and improved enforcement for, all categories of mortgage lenders.
The Federal Reserve continues to work with financial institutions, public officials, and community groups around the country to help homeowners avoid foreclosures. We have called on mortgage lenders and servicers to pursue prudent loan workouts and have supported the development of streamlined, systematic approaches to expedite the loan modification process. We also have been providing community groups, counseling agencies, regulators, and others with detailed analyses to help identify neighborhoods at high risk from foreclosures so that local outreach efforts to help troubled borrowers can be as focused and effective as possible. We are actively pursuing other ways to leverage the Federal Reserve's analytical resources, regional presence, and community connections to address this critical issue.
In addition to our consumer protection efforts in the mortgage area, we are working toward finalizing rules under the Truth in Lending Act that will require new, more informative, and consumer-tested disclosures by credit card issuers. Separately, we are actively reviewing potentially unfair and deceptive practices by issuers of credit cards. Using the Board's authority under the Federal Trade Commission Act, we expect to issue proposed rules regarding these practices this spring.
Thank you. I would be pleased to take your questions.
Part 1
Overview: Monetary Policy and the Economic Outlook
The U.S. economy has weakened considerably since last July, when the Federal Reserve Board submitted its previous Monetary Policy Report to the Congress. Substantial strains have emerged in financial markets here and abroad, and housing-related activity has continued to contract. Also, further increases in the prices of crude oil and some other commodities have eroded the real incomes of U.S. households and added to business costs. Overall economic activity held up reasonably well into the autumn despite these adverse developments, but it decelerated sharply in the fourth quarter. Moreover, the outlook for 2008 has become less favorable since last summer, and considerable downside risks to economic activity have emerged. Headline consumer price inflation picked up in 2007 as a result of sizable increases in energy and food prices, while core inflation (which excludes the direct effects of movements in energy and food prices) was, on balance, a little lower than in 2006. Nonetheless, with inflation expectations anticipated to remain reasonably well anchored, energy and other commodity prices expected to flatten out, and pressures on resources likely to ease, monetary policy makers generally have expected inflation to moderate somewhat in 2008 and 2009. Under these circumstances, the Federal Reserve has eased the stance of monetary policy substantially since July.
The turmoil in financial markets that emerged last summer was triggered by a sharp increase in delinquencies and defaults on subprime mortgages. That increase substantially impaired the functioning of the secondary markets for subprime and nontraditional residential mortgages, which in turn contributed to a reduction in the availability of such mortgages to households. Partly as a result of these developments as well as continuing concerns about prospects for house prices, the demand for housing dropped further. In response to weak demand and high inventories of unsold homes, homebuilders continued to cut the pace of new construction in the second half of 2007, pushing the level of single-family starts in the fourth quarter more than 50 percent below the high reached in the first quarter of 2006.
After midyear, as losses on subprime mortgages and related structured investment products continued to mount, investors became increasingly skeptical about the likely credit performance of even highly rated securities backed by such mortgages. The loss of confidence reduced investors' overall willingness to bear risk and caused them to reassess the soundness of the structures of other financial products. That reassessment was accompanied by high volatility and diminished liquidity in a number of financial markets here and abroad. The pressures in financial markets were reinforced by banks' concerns about actual and potential credit losses. In addition, banks recognized that they might need to take a large volume of assets onto their balance sheets--including leveraged loans, some types of mortgages, and assets relating to asset-backed commercial paper programs--given their existing commitments to customers and the increased resistance of investors to purchasing some securitized products. In response to those unexpected strains, banks became more conservative in deploying their liquidity and balance sheet capacity, leading to tighter credit conditions for some businesses and households. The combination of a more negative economic outlook and a reassessment of risk by investors precipitated a steep fall in Treasury yields, a substantial widening of spreads on both investment-grade and speculative-grade corporate bonds, and a sizable net decline in equity prices.
Initially, the spillover from the problems in the housing and financial markets to other sectors of the economy was limited. Indeed, in the third quarter, real gross domestic product (GDP) rose at an annual rate of nearly 5 percent, in part because of solid gains in consumer spending, business investment, and exports. In the fourth quarter, however, real GDP increased only slightly, and the economy seems to have entered 2008 with little momentum. In the labor market, growth in private-sector payrolls slowed markedly in late 2007 and January 2008. The sluggish pace of hiring, along with higher energy prices, lower equity prices, and softening home values, has weighed on consumer sentiment and spending of late. In addition, indicators of business investment have become less favorable recently. However, continued expansion of foreign economic activity and a lower dollar kept U.S. exports on a marked uptrend through the second half of last year, providing some offset to the slowing in domestic demand.
Overall consumer price inflation, as measured by the price index for personal consumption expenditures (PCE), stepped up to 3-1/2 percent over the four quarters of 2007 because of the sharp increase in energy prices and the largest rise in food prices in nearly two decades. Core PCE price inflation picked up somewhat in the second half of last year, but the increase came on the heels of some unusually low readings in the first half; core PCE price inflation over 2007 as a whole averaged slightly more than 2 percent, a little less than in 2006.
The Federal Reserve has taken a number of steps since midsummer to address strains in short-term funding markets and to foster its macroeconomic objectives of maximum employment and price stability. With regard to short-term funding markets, the Federal Reserve's initial actions when market turbulence emerged in August included unusually large open market operations as well as adjustments to the discount rate and to procedures for discount window borrowing and securities lending. As pressures intensified near the end of the year, the Federal Reserve established a Term Auction Facility to supply short-term credit to sound banks against a wide variety of collateral; in addition, it entered into currency swap arrangements with two other central banks to increase the availability of term dollar funds in their jurisdictions. With regard to monetary policy, the Federal Open Market Committee (FOMC) cut the target for the federal funds rate 50 basis points at its September meeting to address the potential downside risks to the broader economy from the ongoing disruptions in financial markets. The Committee reduced the target 25 basis points at its October meeting and did so again at the December meeting. In the weeks following that meeting, the economic outlook deteriorated further, and downside risks to growth intensified; the FOMC cut an additional 125 basis points from the target in January--75 basis points on January 22 and 50 basis points at its regularly scheduled meeting on January 29-30.
Since the previous Monetary Policy Report, the FOMC has announced new communications procedures, which include publishing enhanced economic projections on a timelier basis. The most recent projections were released with the minutes of the January FOMC meeting and are reproduced in part 4 of this report. Economic activity was expected to remain soft in the near term but to pick up later this year--supported by monetary and fiscal stimulus--and to be expanding at a pace around or a bit above its long-run trend by 2010. Total inflation was expected to be lower in 2008 than in 2007 and to edge down further in 2009. However, FOMC participants (Board members and Reserve Bank presidents) indicated that considerable uncertainty surrounded the outlook for economic growth and that they saw the risks around that outlook as skewed to the downside. In contrast, most participants saw the risks surrounding the forecasts for inflation as roughly balanced.
By Carla Mozee, MarketWatch
Last update: 2:50 p.m. EST Feb. 28, 2008
SAN FRANCISCO (MarketWatch) -- Dell Inc., Gap Inc. and American International Group Inc. will be in the late-trading spotlight Thursday with the release of quarterly results from the technology retailer, the clothing chain and the insurance giant.
Dell (DELL :) is expected to show signs of new growth and growing market share when it reports fourth-quarter results. Analysts polled by FactSet Research are looking for earnings of 36 cents a share on revenue of $16.24 billion in sales. See earnings preview.
Ahead of the results, stock in Dell was up 0.8% to $20.93.
OmniVision Technologies Inc. (OVTI:) , which makes image sensors used in digital cameras, cell phones and computers, is expected to report earnings of 42 cents a share on $226 million for its fiscal third quarter.
Sapient Corp. (SAPE:) is forecast to report earnings of 5 cents a share on sales of $146.4 million for the fourth quarter. Shares of the technology and business consulting firm were off 3% at $6.27, at last check.
Gap (GPS:) is expected to post a profit of 33 cents a share on sales of $4.75 billion for the fourth quarter.
Analysts are looking for Kohl's (KSS:) earnings to come in at $1.34 a share on revenue of $15.54 billion for the fourth quarter. Shares of Kohl's fell 3.4% to $45.33 in afternoon trade.
American International Group (AIG:) is forecast to report per-share earnings of 60 cents for the fourth quarter. Its shares were last down 3.6% to $50.39.
Wall Street expects Viacom Inc. (VIAB:) (VIA:) to report fourth-quarter earnings of 83 cents a share on $4.05 billion.
By Carla Mozee, MarketWatch
Last update: 8:00 p.m. EST March 3, 2008
SAN FRANCISCO (MarketWatch) -- Intel Corp. shares fell Monday evening after the world's largest chipmaker cut its quarterly margin forecast, and shares of Barnes & Noble Inc. lost ground after the book retailer's forecast for quarterly adjusted earnings came in lighter than analysts' expectations.
The Nasdaq-100 After Hours Indicator, which tracks the late action in the index's leading stocks, fell 3 points, or 0.2%, to end at 1,729.62.
Intel (INTC:) fell 2.4% to $20.01 following the company's new first-quarter gross margin forecast, of between 53% and 55%. It previously forecast gross margin or 56%, plus or minus a couple of points. The company cited lower than expected NAND flash-memory chip prices as reason for the lowered outlook. The company reaffirmed all of its other forecasts for the first quarter.
Shares of rival chipmaker Advanced Micro Devices Inc. (AMD:) fell 0.9% to$6.70, and Texas Instruments Inc. (TXN:) shed 0.5% to $29.78.
Stock in Barnes & Noble (BKS:) fell 5.9% to $26.67 in light volume. The company raised its fourth-quarter net earnings forecast to $1.76 to $1.82 a share, but excluding 10 cents a share in benefits related to property insurance and litigation settlements, the company foresees earnings at the midrange of its previous outlook for $1.57 to $1.76 a share.
The midrange of that forecast is $1.66 a share, and analysts polled by FactSet Research are looking for earnings of $1.72 a share.
Barnes & Noble also reported a fourth-quarter increase in store sales to $1.51 billion, excluding the impact of an extra week in the 2006 retail calendar. Same-store sales fell 0.5% from the year-ago period.
Stock in KLA-Tencor Corp. (KLAC:) reversed earlier gains to end 1.5% lower at $41 in light volume after the chip-equipment provider said Chief Financial Officer Jeffrey Hall will resign on March 31. Hall was named as chief financial officer of Express Scripts Inc. (ESRX:), a pharmacy-benefits manager. Express Script shares were down 0.3% at $61.82 in recent trade.
KLA-Tencor named President and Chief Operating Officer John Kispert as interim CFO. Kispert will retain his duties as chief operating officer.
Elsewhere, Fremont General Corp. (FMT:) dropped 4.2% to 67 cents as the subprime lender's shares moved off the S&P SmallCap 600 index during the evening session.
Among large-volume tech movers, Microsoft Corp. (MSFT:) shed 0.3% to $26.90, Yahoo Inc. (YHOO:) rose 0.3% to $27.85, and Dell Inc. (DELL:) fell 0.9% to $19.76.
The Nasdaq-100 After Hours Indicator, which tracks the late action in the index's leading stocks, fell 3 points, or 0.2%, to end at 1,729.62.
By John Letzing, MarketWatch
Last update: 7:55 p.m. EST March 3, 2008
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SAN FRANCISCO (MarketWatch) -- Intel Corp. late Monday lowered its gross-margin outlook for its fiscal first-quarter due to lower NAND flash-memory chip prices than expected.
Santa Clara, Calif.-based Intel (INTC: 20.01, +0.04, +0.2%) said in a statement that it's lowering its gross-margin forecast for the quarter to roughly 54% from 56%. The chipmaker said no other parts of its outlook issued alongside its fourth-quarter earnings report in January will be affected.
Intel is expected to report its first-quarter earnings in April. Shares of Intel fell more than 2% in after-hours trading, to $19.52.
NAND flash-memory chips are used in products such as mobile devices and USB flash drives, and sales of the technology depend on strong retail-consumer demand.
A glut of memory chips led to price declines for a number of companies in 2007, according to a report issued last month by the Semiconductor Industry Association, leading to only marginal growth in total chips revenue for the year. See related story.
In addition, J.P. Morgan analyst Christopher Danley last week cited "excess microprocessor inventory" when cutting his earnings estimates for Intel's fiscal 2008 and 2009.
By MarketWatch
Last update: 8:32 p.m. EDT March 16, 2008
WASHINGTON (MarketWatch) -- The following is the text of the Federal Reserve statement issued March 16.
The Federal Reserve on Sunday announced two initiatives designed to bolster market liquidity and promote orderly market functioning. Liquid, well-functioning markets are essential for the promotion of economic growth.
First, the Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets. This facility will be available for business on Monday, March 17. It will be in place for at least six months and may be extended as conditions warrant. Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities. The interest rate charged on such credit will be the same as the primary credit rate, or discount rate, at the Federal Reserve Bank of New York.
Second, the Federal Reserve Board unanimously approved a request by the Federal Reserve Bank of New York to decrease the primary credit rate from 3-1/2 percent to 3-1/4 percent, effective immediately. This step lowers the spread of the primary credit rate over the Federal Open Market Committee's target federal funds rate to 1/4 percentage point. The Board also approved an increase in the maximum maturity of primary credit loans to 90 days from 30 days.
The Board also approved the financing arrangement announced by JPMorgan Chase & Co. and The Bear Stearns Companies Inc.
Bear Stearns shocker triggers forecasts for whopper cut to 2%
By Laura Mandaro, MarketWatch
Last update: 7:52 p.m. EDT March 14, 2008
SAN FRANCISCO (MarketWatch) -- Expectations that Federal Reserve next week will cut rates by a full percentage point, to 2%, gained traction among economists and traders Friday after a bailout of Bear Stearns Cos. revealed more fault lines in the U.S. financial system.
Citigroup economists said they anticipate Fed policy-makers will lower the federal funds rate by a point to 2% next week from the current 3%, "and more cannot be ruled out."
"Aggressive action is needed to stabilize the financial setting," according to economists in a research report led by Citi's Robert DiClemente. The decision by the New York Fed and JPMorgan Chase & Co. (JPM) to provide financing to Bear Stearns (BSC) "underscores the current fragility of the system."
On Friday, Bear Stearns said that it was forced to draw on short-term financing from the Fed, through J.P. Morgan, after its liquidity "deteriorated significantly" during the past 24 hours. The news sank stocks and pushed investors further into bonds and commodities, which are increasingly seen as a safe haven to market disruptions. See full story.
Credit-market troubles and slowing growth have the potential to unleash the worst U.S. recession in more than 25 years, the Citigroup economists said.
Also feeding into expectations of deeper rate cuts, the Labor Department announced that consumer inflation in February was flat from January, or less than economists were anticipating, though prices gained 4% from the year-ago month. See full story.
Economists in general have been more cautious on the likelihood of rate cuts than the futures market, though they have raised their expectations recently.
Those surveyed by MarketWatch now anticipate the Fed will cut rates by 75 basis points next week, to 2.25%, deeper than the 50-basis point cut they anticipated a week ago.
Since it started cutting rates in September during the first wave of global credit crunch, the central bank has slashed interest rates to 3% from 5.25%. As problems in the subprime-mortgage market spread to other parts of the banking system, creating big write-downs on Wall Street and freezing whole pockets of the credit market, it jumped in with bigger, surprise cuts this year.
Led by Chairman Ben Bernanke, the Fed has used other tools to try to ease the ongoing credit crunch, such as making itself available for $400 billion in bank and broker loans.
The Fed's apparent willingness to loosen the money supply, combined with nearly daily blowups in the financial system, has pushed up the odds on futures that price in the likelihood of rate changes. Traders in this market are now anticipating a 100-basis point cut in March.
The April contract Friday jumped to 97.88, which translates to 100% odds the Fed will lower interest rates by 75 basis points, and more than 50% odds of an additional 25 basis points -- which would bring short-term interest rates to 2%.
On Thursday, federal funds futures priced in 88% odds for just a 75 basis-point cut. Some 42,557 April futures contracts, which market participants use as a snapshot of expectations on the March meeting, traded hands on the Chicago Board of Trade.
One basis point is 1/100th of a percent.
Deutsche Bank economist Joseph LaVorgna said Friday that his bank now believes the Fed will cut rates by 75 basis points on Tuesday, "and the odds of a 100 basis cut are growing."
"There has been no letup in financial market deterioration," he wrote in a research report. "Whether the Fed opts for an unprecedented 100 basis-point move will depend largely on financial-market conditions, namely whether the market further raises the probability of systemic solvency issues." End of Story
By Riley McDermid, MarketWatch
Last update: 7:58 a.m. EDT March 17, 2008
NEW YORK (MarketWatch) -- Investment bank Lehman Brothers Holdings Inc. saw its rating downgraded to stable from positive by Moody's Investors Service Monday, and saw its shares fall as much as 25% in pre-open trading.
Moody's Investors Service said Monday that it affirmed its A1 rating on the senior long-term debt of Lehman Brothers (LEH 39.26, -6.73, -14.6%) , but lowered its outlook on Lehman ratings to stable from positive.
"Today's rating action recognizes that Lehman has navigated quite well to date through persistently volatile and challenging financial markets, the sharp market-wide decline in valuations across numerous asset classes, tight global liquidity conditions, and the strong head winds facing Lehman's (and other securities firms') core-earnings drivers.
"However, these conditions have decreased the upward pressure on Lehman's rating, and therefore a positive outlook is no longer warranted," Moody's said in its ratings decision.
Rival brokerages Morgan Stanley (MS) and Goldman Sachs (GS) also saw their shares trading significantly lower in pre-market trading, with Morgan down almost 7% and Goldman Sachs falling nearly 8%.
On Sunday J.P. Morgan Chase and Co. (JPM) agreed to buy struggling brokerage Bear Stearns (BSC) for $236 million, or $2 a share, in an unprecedented Fed-supported rescue. See related story.
The Federal Reserve also said Sunday that it will cut the discount rate.
By Steve Goldstein
Last update: 4:34 a.m. EDT March 17, 2008
LONDON (MarketWatch) -- April-dated fed fund futures contracts rose 11 cents to 97.98 -- implying a 90% chance that the Fed will slash its base rate to 2%. End of Story
By Riley McDermid, MarketWatch
Last update: 12:23 p.m. EDT March 17, 2008
NEW YORK (MarketWatch) -- Analysts who cover broker Lehman Bros. were laying low Monday, saying they did not want to add to market speculation that the firm may be the next major brokerage under the gun.
"All of the investment banks rely on repurchase agreements to fund a significant amount of assets. If market participants begin to fear that another bank is facing a liquidity crisis, we could see another collapse," said Morningstar analyst Ryan Lentell in a research note.
"Rumors of problems at Bear gained traction because of the bank's exposure to the residential mortgage market, which has been in turmoil," Lentell said. "The investment banks all have exposure to these asset classes, and as fear over further price declines in any one asset class escalates, it could lead to a run on another bank."
Shares of Lehman Bros. temporarily recovered some of their early losses Monday as the broader markets calmed down after being rattled by an eleventh-hour bailout of rival Bear Stearns. But after rebounding to a smaller 14% loss, Lehman fell back to a loss of more than 30%.
Early Monday, Moody's Investors Service trimmed its outlook on the investment bank's debt rating, heightening concerns about liquidity. The ratings agency affirmed its A1 rating on the senior long-term debt of Lehman Brothers (LEH 22.69, -16.54, -42.2%) but lowered its outlook on Lehman ratings to stable from positive.
Moody's said its ratings action "recognizes that Lehman has navigated quite well to date through persistently volatile and challenging financial markets, the sharp market wide decline in valuations across numerous asset classes, tight global liquidity conditions, and the strong headwinds facing Lehman's (and other securities firms') core-earnings drivers."
"However, these conditions have decreased the upward pressure on Lehman's rating, and therefore a positive outlook is no longer warranted," the ratings agency said.
UBS also downgraded Lehman Bros. to neutral on concerns that the bank will see further trouble in the capital markets.
If the current losses hold throughout Monday's session, it would easily be the stock's biggest one-day percentage drop since they started publicly trading in May 1994.
Previously, the biggest one-day percentage drop for Lehman shares was 18.6% on April 14, 2000, in the thick of the dot-com meltdown.
Rival brokerages Morgan Stanley (MS ) and Goldman Sachs Group (GS 142.27, -14.59, -9.3%) also saw their shares trading significantly lower in pre-market trading -- down nearly 7% and nearly 8%, respectively.
Another shoe to drop?
Touching off the shivers on Wall Street, J.P. Morgan Chase & Co. (JPM 39.28, +2.74, +7.5%) agreed to buy struggling brokerage Bear Stearns Cos. (BSC 3.66, -26.34, -87.8%) for $236 million, or $2 a share, in an unprecedented rescue supported by the Federal Reserve. The Fed also moved to cut the discount rate to 3.25%. See related story.
Market rumors have pegged Lehman as the next investment house to face the same type of withering scrutiny that Bear Stearns came under last week. How well Lehman will survive such a storm remains to be seen, several analysts said.
"The concern is that every Wall Street firm will be viewed in light of the Bear Stearns sale price," Robert Brusca, chief economist at Fact and Opinion Economics, said on Sunday evening.
Other analysts seconded that opinion, saying that without going into too many specifics about Lehman's core businesses, it is easy to see why the firm will face greater obstacles in the near future.
"There is no question that they are a well managed shop, but this problem is much larger than Lehman," said Mark Williams, who teaches finance at Boston University School of Management and used to be an official at the Federal Reserve official.
"The Fed actions were great for Bear Stearns, but they didn't address the whole industry," Williams said. "Going forward, Bernanke is going to need to act a lot less like a quarterback and a lot more like a facilitator."
Williams said that without further intervention from the Fed, only the strongest institutions will survive, because the market is "gruesomely efficient" in deciding who will survive on the capital markets.
But investor confidence and access to liquidity are only some of the obstacles Lehman may face.
"During a crisis of confidence, earnings, book value and liquidity don't matter much," Citigroup analyst Prashant Bhatia wrote in a research note Monday. "Client and counterparties vote with their money and if confidence breaks down rapid deterioration will likely follow."
These are problems endemic to the industry, analysts said.
"It is not bad trading decisions or credit losses that end the life of one of these institutions; rather, it is the inability to rollover debt when it comes due," Hintz said. "As such, liquidity risk has remained the Achilles heel of the securities firms."
But Lehman Brothers faces different challenges than its rival firms, due to its large mortgage operations and broader exposure.
"Company-specific risks include subpar performance in trading-related businesses, declining business performance as a result of losing talent, risk management and lack of financial liquidity in the event of shock-type events," Bhatia said.
Lehman has already been feeling the fallout from that lack of confidence. The firm had a scare this weekend after published reports Sunday said that the Development Bank of Singapore was discontinuing all transactions with the bank. However, both parties said Monday that those reports were false.
Lehman got some good news Friday, when it announced that a new credit facility was "substantially oversubscribed." Lehman replaced its existing three-year credit facility with a $2 billion committed unsecured facility.
The bank said it was particularly encouraged by the large number of banks that participated in the facility -- more than 40 -- and by the actions of co-leaders J.P. Morgan Chase and Citigroup (C 18.23, -1.55, -7.8%) .
"We are extremely pleased with the success of the syndicated facility and view this as a strong signal from the market and our key bank relationships," said Paolo Tonucci, Lehman's global treasurer.
Citigroup analysts rated Lehman shares as "high risk" Sunday, saying the bank is particularly vulnerable to the macroeconomic environment, including "the strength of the economy and strength of the operating environments for investment banking, trading, origination and global financial asset values."
The market echoed those worries, with analysts looking ahead to when Lehman reports first-quarter financial results before the market opens on Tuesday.
Analysts surveyed by Thomson Financial have been expecting earnings of 72 cents a share, on average, with revenue pegged to drop more than 60% from a year earlier.
Some analysts remain bearish on the stock, worried about continuing write-downs and the state of global credit markets worldwide. Oppenheimer & Co. analyst Meredith Whitney, for one, slashed her first-quarter profit estimate for Lehman to 50 cents a share.
Analysts also are anticipating that revenue will fall 34% to $3.35 billion for the quarter.
Messy quarterly reports
Indeed, analysts and market players surveyed by FactSet Research expect all four of the largest U.S. investment banks to have suffered mightily in the first quarter, with earnings for Morgan Stanley, Goldman, Bear Stearns and Lehman to have been halved from the same period last year.
But Lehman has attempted to stay ahead of the curve when planning for 2008, trimming its operations wherever it can and investing heavily in a well-publicized risk-management team.
The broker also cut nearly 4,000 jobs in the last year and now has around 28, 600 employees. The bank has said it aims to trim its total workforce by 5% globally in the next 12 months.
The trend to downsize has been a major theme for the nation's five largest investment banks, with both Goldman Sachs streamlining its work force and Morgan Stanley laying off more than 2,000 workers this year.
As part of that downsizing, published reports said Monday, Lehman has shut down its European credit strategy team in London, including reassigning David Brickman, who was head of European credit strategy, and Ben Bennett, previously director of European credit strategy.
But despite some market stabilization Monday, Hintz said that Sanford Bernstein is advising clients to stay out of the brokerage arena, at least for now.
"We would not recommend getting into the large capitalization names at this time. The unfortunate events at BSC will lead to sharply increasing funding pressure on the other four large capitalization brokers in the near term," Hintz said. "Although [Morgan Stanley, Goldman Sachs, Bear Stearns and Lehman Bros.] have strong capital bases and capable corporate treasuries and repo desks, investing in the brokers now is a bet on a recovery of confidence in credit markets that are experiencing the worst turmoil in several decades. "
It is a lesson other corporate executives need to take to heart, Williams said.
"If executives think they can just stand up and say everything is okay until things get better, then they are wrong," Williams said. "Everything is not okay. They need to have a broader plan." End of Story
Bear shareholders may try to get higher offer
Stock price suggests J.P. Morgan bid may be put off until market calms down
By Alistair Barr, MarketWatch
Last update: 6:23 p.m. EDT March 17, 2008
SAN FRANCISCO (MarketWatch) -- During a conference call held by J.P. Morgan Chase & Co. Sunday to discuss its offer to buy Bear Stearns Cos., an individual investor in the beleaguered brokerage firm announced that he would vote against the fire-sale deal.
The comment by a person identifying himself as Brian Firestone was followed by a brief silence. Then J.P. Morgan (JPM 42.66, +2.35, +5.8%) executives moved on to the next question.
But the prospect that Bear Stearns investors may reject the bank's offer of $2 a share -- at least for a few months -- is now being priced into the market, analysts said Monday.
J.P. Morgan's offer is worth more than $2 a share because the bank's stock (the currency it's using to try to purchase Bear) climbed 10% on Monday. Bear shares closed at $4.81 -- roughly double the value of the bid.
Indeed, Joseph Lewis, one of Bear Stearns' largest shareholders, told CNBC on Monday that J.P. Morgan's offer was "derisory." The currency-trading billionaire owns almost 10% of the brokerage firm, having built a stake since September when the shares were trading at more than $100.
"People are speculating that shareholders aren't going to approve the deal for a while," said Ryan Lentell, an equity analyst at Morningstar, in an interview. "If market conditions improve, they may be able to negotiate for a higher price or another bidder may come to the table."
As part of the deal, J.P. Morgan immediately guaranteed all of Bear Stearns' (BSC) trading obligations to try to encourage counterparties and clients to keep trading with the firm.
That guarantee remains in place until the acquisition closes and Bear is subsumed into J.P. Morgan's operations. However, if Bear shareholders reject the deal, they have to vote on it several more times over the next 12 months. During that time, the guarantee from J.P. Morgan remains in place, executives from the bank indicated Sunday.
"The guarantee applies to all transactions on the books today and any transactions that are entered into while that guarantee is in place," Bill Winters, co-chief executive of J.P. Morgan's investment bank, said during the Sunday conference call.
"We all firmly believe that the shareholders at Bear Stearns will approve the transaction," added Steve Black, who runs J.P. Morgan's investment bank with Winters. "If they were to choose not to approve it, then the guarantee would eventually go away when that process has run its course, which is over the course of 12 months."
Bear shareholders may be thinking that if they vote the deal down for several months, markets may calm down and the value of the brokerage firm may recover, leaving them room to ask for more money from J.P. Morgan, Morningstar's Lentell said. In the meantime, J.P. Morgan's guaranty remains in place for as long as a year.
This strategy also increases that chance that another bidder may appear later on, he elaborated. "You wouldn't get another bidder until the markets recover," he commented.
Bear Stearns shares fell 84% to $4.81. J.P. Morgan shares climbed 10% to $40.31.
Bankruptcy option
Still, Bear shareholders may have been left with nothing if the firm wasn't acquired quickly and had to file for bankruptcy protection instead, experts said.
In that scenario, the firm's assets may have been sold at big discounts and counterparties may not have been able to collect quickly on their positions, leading to wider problems across the financial system, they explained.
"Had it gone into bankruptcy the systemic risk for the economy would be very large," Josh Lerner, the Jacob H. Schiff Professor of Investment Banking at Harvard Business School, said in an interview.
A particular concern was Bear's derivatives business, which is a counterparty on credit-default swaps (CDS), a type of derivative that pay out in the event of default.
If Bear went bankrupt, all the firm's CDS agreements with hedge funds and other counterparties would have to be unwound, Lerner said.
"Someone who bought CDS from Bear to hedge positions wouldn't be able to reconstruct that hedge again," Lerner said. "Take that situation and multiply it by maybe 100,000 and you get a sense of how ugly it would be."
Indeed, J.P. Morgan was probably a major counterparty to Bear in the market for CDS and other financial products, said John Jay, senior analyst at Aite Group, a financial-services research firm.
"J.P. Morgan has pretty good motivation for getting this deal done," Jay said in an interview. "They're getting businesses that they've wanted all along and will avoid a bankruptcy situation, which may have taken a long time and is usually a complete mess."
By MarketWatch
Last update: 2:18 p.m. EDT March 18, 2008
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WASHINGTON (MarketWatch) - The Federal Open Market Committee released the following statement following its closed-door meeting on Tuesday:
The Federal Open Market Committee decided today to lower its target for the federal funds rate 75 basis points to 2-1/4 percent.
Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.
Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully.
Today's policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will act in a timely manner as needed to promote sustainable economic growth and price stability.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Gary H. Stern; and Kevin M. Warsh. Voting against were Richard W. Fisher and Charles I. Plosser, who preferred less aggressive action at this meeting.
In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 2-1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, and San Francisco.
