Evening Update

Street Discounts Early Fed Rate-Induced Sell-off

After opening the day in the red on the heels of the surprising move by the Federal Reserve to get on the track to normalization by increasing its discount rate, stocks have overcome early losses and are higher in afternoon action. A softer-than-expecting report on consumer prices, highlighted by an unexpected drop in the core rate, helped the bulls rebound and the equity markets move into positive territory. Treasuries are flat as traders grapple with the inflation and Fed interest rate action, while the dollar continues to post a solid gain versus most major currencies. However, the afternoon advance is having little impact on computer firm Dell, as its better-than-expected profit report is being overshadowed by worries about its gross margins. In other equity news, J.C. Penney and CBS Corp. both reported earnings that exceeded analysts’ expectations, Honeywell International increased its 1Q EPS outlook, and the Wall Street Journal reported that oil-services company Schlumberger Ltd is in advanced discussions to acquire rival Smith International Inc. Overseas, Europe erased early losses along with the US markets and finished higher.

At 12:54 p.m. ET, the Dow Jones Industrial Average is 0.3% higher, the S&P 500 Index is up 0.4%, and the Nasdaq Composite is advancing 0.3%. Crude oil is $0.49 higher at $79.55 per barrel, wholesale gasoline is up $0.02 at $2.09 per gallon, and the Bloomberg gold spot price is higher by $14.93 at $1,123.63 per ounce. Elsewhere, the Dollar Index—a comparison of the US dollar to six major world currencies—is up 0.6% at 80.88.

Dell Inc. (DELL $13) reported 4Q EPS ex-items of $0.28, one penny above the consensus estimate of Wall Street analysts, with revenues increasing 11% year-over-year to $14.9 billion, versus the $13.8 billion that analysts had anticipated. DELL said its product shipments rose 16% y/y, with notebook shipments up 32% y/y. However, shares were under heavy pressure as traders reacted negatively to the company’s gross margin performance, which came in at 17.4% of revenue ex-items, pressured by seasonal strength in the consumer segment, which has lower margins according to the company.

J.C. Penney (JCP $28) reported 4Q EPS of $0.84, two cents above the Street’s expectation, with revenues declining 3.6% y/y to $5.6 billion, compared to the $5.5 billion that analysts were anticipating. JCP said its strongest merchandise results were in women’s apparel and shoes, while the best geographical performance came in the central region of the country. JCP issued 1Q EPS guidance that was mostly inline with expectations, while it reported a full-year earnings outlook that topped the Street’s expectations. Shares were nicely higher.

Honeywell International (HON $40) was higher after the industrial firm increased its fiscal 1Q EPS guidance from a range of $0.35-0.40, per Reuters, to $0.40-0.45, reflecting the company’s continued strong operational performance and excludes the potential negative impact of proposed healthcare legislation that was previously included in its guidance. HON also confirmed that 1Q sales are expected to be between $7.2-7.6 billion, and re-affirmed its full-year 2010 guidance. The company said its outlook is “bright” and that it “performed well in the last recovery, well in the recession, and will perform even better in this recovery.” Analysts were expecting the company to report 1Q EPS of $0.42.

CBS Corp. (CBS $14) announced adjusted 4Q earnings of $0.25 per share, inline with analysts’ forecasts, with revenues roughly flat y/y at $3.5 billion, but slightly above the $3.4 billion that the Street had anticipated. The company said higher national ad sales, growth in affiliate and subscription fees, and improvement in the local television marketplace, were offset by lower radio, outdoor and political ad sales, and continued softness in the publishing retail market. CBS added that rising revenue trends are continuing and it sees a number of very positive signs at both its content and local groups. Shares were higher.

The Wall Street Journal is reporting that oil-services company Schlumberger Ltd.(SLB $64) is in advanced discussions to acquire Smith International Inc. (SII $38). The report cites people familiar with the matter, and notes that the deal would create an oil-field company with revenues that would double that of the nearest industry rival. The companies did not comment. SII was up over 10% and SLB was under pressure.

Fed hikes discount rate sooner than expected, says not a signal of tightening

Just after yesterday’s closing bell, the US Federal Reserve announced, along with other measures intended as “a further normalization of the Federal Reserve’s lending facilities,” that it will increase its discount interest rate—a primary credit rate for banks to obtain short term loans from the Fed—from 0.5% to 0.75%. The Fed said that the changes came “in light of continued improvement in financial market conditions,” and the increased discount rate widens the spread compared to the federal funds rate to 0.5%, aimed at encouraging depository institutions to rely on private funding markets for short-term credit and to use the Fed’s primary credit facility only as a backup source of funds. The Fed said it will assess over time whether further increases in the spread are appropriate in view of experience with the 0.5% percentage point spread.

The Board of Governors vote was unanimous and although last week’s testimony from Fed Chief Ben Bernanke and this week’s release of the Fed’s monetary policy meeting minutes noted that the Fed was going to take this action soon, the decline in S&P 500 futures entering the day suggested the increase came sooner than some had expected. The Fed added that these modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy. There is only a small amount of lending done at the discount rate, and the discount window is intended to serve as a last resort for short-term bank borrowing. The Fed maintained its outlook that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” Other actions that the Fed announced included shortening of maximum maturity for primary credit loans to overnight and raising the minimum bid rate for its Term Auction Facility (TAF).

Several Fed officials commented, reinforcing the “normalization” nature of the action. New York Fed President Dudley provided further color, saying that while the spread was 100 bps before the crisis, “We don’t have a clear goal that 50 or 100 bps will be the final resting place,” adding that “things are back to normal in terms of how banks lend to each other,” and “As a consequence, we could go back to normal in terms of the spread.”

Consumer prices soft, painting a different picture from the wholesale price report

Treasuries were higher on the day, with the yield on the 2-year note falling 1 bp to 0.92%, the yield on the 10-year note losing 2 bps to 3.78%, and yield on the 30-year bond decreasing 2 bps to 4.71%.

The Consumer Price Index(chart) showed prices at the consumer level rose 0.2% in January month-over-month (m/m), below the forecast of economists surveyed by Bloomberg, which called for the index to rise 0.3%. Meanwhile, the core rate, which strips out food and energy, unexpectedly fell, declining by 0.1% m/m for January, versus the Street’s forecast of a 0.1% advance. The decline was the first decrease in the core since 1982, according to Bloomberg. While food and energy is the smallest component in the CPI basket, it tends to be the most volatile and often explains a majority of changes in the index at the headline level. On a year-over-year basis, consumer prices were up 2.6% in January, compared to the forecast of 2.8%, and the core CPI was 1.6% higher year-over-year, compared to the 1.8% forecast.

However, even as the inflation report today soothed some concerns, digging into the release by the Bureau of Labor Statistics, there were some data points that are worth noting, as they could provide some pressure on the discretionary income of the vital consumer. The headline increase in the CPI came as a result of a rise in the energy index, with an increase in gasoline being the main factor. Moreover, the food index rose, with the food at home component posting its largest increase since September 2008, due to sharp increases in dairy and fruits and vegetables. Even though the Fed tends to look at the core rate, which excludes food and energy and unexpectedly moved down to 1.6% y/y—compared to the Fed’s implied target of between 1-2%—higher gas and food bills for households eat away at available funds for spending and should be something worth keeping an eye for their implications on the continuation of the economic recovery. Although one month does not constitute a trend, January’s inflation reports this week have garnered more discussion on the inflationary front relative to recent months, and will likely gain more steam as the focus on the timing of the Fed’s exit strategy emerges to front of the minds of traders.

International economic calendar active in Europe but light in Asia/Pacific

The Eurozone economic calendar was also plentiful today, as several PMI results were reported for February, with French manufacturing and services both missing economists’ forecasts, while German PMI manufacturing exceeded expectations but its service activity came up short, and the overall Eurozone PMI’s showed that service activity missed forecasts and manufacturing exceeded estimates. Outside of the PMI reports, German producer prices rose more than expected m/m in January, Italian industrial orders unexpectedly jumped m/m in December, while UK retail sales dropped more than forecasted m/m in January.

Reserve Bank of Australia Governor Glenn Stevens noted that the Australian economy has less room for growth without stoking inflation, saying, “Monetary policy must therefore be careful not to overstay a very expansionary setting,” he told a parliamentary committee hearing today per Bloomberg News. The comments may have increased the outlook for further rate hikes by the RBA, which has raised its benchmark lending rate three out of the four previous monetary policy meetings, after surprising some earlier this month by keeping its main lending rate unchanged at 3.75%.

Back in the green on a heavy dose of economic data

Even though the week was shorter than normal due to Presidents Day, stocks posted solid gains across the board as the economic calendar and equity front yielded plenty of sustenance for the bulls and the S&P 500 Index and the Dow Jones Industrials moved close to breaking above the flatline for the year. The equity front added some pep to the bulls’ step, with earnings reports for the most part continuing to exceed the Street’s forecasts and more M&A activity hitting the Street, boosting confidence about growing optimism in the corporate sector.

The economic front also lifted sentiment, with several reports pointing to the continuation of the economic recovery. Industrial production rose more than economists expected, while housing starts and building permits posted annual rates that came in above forecasts. Also, regional manufacturing reports depicted activity in the New York and Mid-Atlantic regions—with both reports showing improving employment conditions—while the Index of Leading Economic Indicators posted the tenth-consecutive monthly increase to contribute to economic optimism.

However, this week was not without its struggles as the bulls had to show some resiliency in face of heightened uncertainty regarding when the Fed will begin tightening its monetary policy, and judging by the overnight and early reaction on Friday to the increase in the discount rate, there is some skittishness regarding the prospect of the Fed moving to a less accommodative policy in the near term. This sentiment was also exposed by the see-saw reaction to this week’s conflicting inflation reports. This week’s release of the Fed’s minutes from its January policy meeting added to the uncertainty, suggesting officials may have been further down the exit-strategy road than some anticipated as it showed that several policymakers thought it important to begin a program of asset sales in the near future.

Next week chock full of economic data

A busy economic week starts Tuesday with release of the S&P/CaseShiller Home Price Index, which lags the sales data by a month and is expected to show prices declined 3.0% y/y for December. New home sales will be released on Wednesday, forecasted to increase 2.6% m/m in January to an annual rate of 351,000 units, after unexpectedly falling 7.6% in December, as weakness persisted in contract signings despite the extension and expansion of the tax credit, as the month is seasonally weak due to holidays and there was cold weather in many areas of the country. Despite the weakness, there was a glimmer of good news, in that trade-up homes grew as a percentage of sales. Existing-home sales will be reported on Friday, expected to have increased 0.9% m/m in January to an annual rate of 5.5 million units, and reflect closings from contracts entered one to two months earlier.

Durable goods orders will be reported on Thursday, expected to rise 1.4% m/m in January, while ex-transportation, orders are forecasted to have grown 1.1% m/m. The durable goods data is volatile on a month-to-month basis as the large size of orders for items such as airplanes and military equipment can have a tendency to distort the data.

Friday brings the second reading of Advance Gross Domestic Product (GDP) for 4Q, considered a proxy for corporate profits. Economists are expecting the growth rate to be revised down to 5.6% from the 5.7% initially reported, which used estimates of some data that have been subsequently released. The initial figure was primarily driven by a positive contribution from inventories of 3.4%, as stocks of goods fell at a slower rate, as well as a 1.4% contribution from consumer spending, and a 0.8% contribution from capital spending on equipment and software, which rose at a 13.3% pace in 4Q, the most since 2006.

Other reports on next week’s US economic calendar include the Chicago Fed National Activity Index, the Richmond Fed Manufacturing Index, the MBA Mortgage Applications Index, initial jobless claims, the Conference Board Consumer Confidence Index and the University of Michigan consumer sentiment survey. Additionally, Bernanke will be delivering his semi-annual testimony before the House and Senate on Wednesday and Thursday.

Economic releases in Asia/Pacific next week include Japan retail sales, household spending, consumer prices, industrial production, construction, and housing starts. Australia will announce its leading index.

In Europe, releases include the Eurozone industrial new orders, consumer confidence, and CPI, the final reading on German 4Q GDP, as well as German consumer confidence, employment and the IFO survey of business confidence, French employment, PPI, and consumer confidence, UK preliminary 4Q GDP, home prices, business investment, and consumer confidence. Releases in the Americas include Brazil retail sales and employment.