Evening Market Update

Fed Supports With Purchases to Keep Holdings Constant

Markets closed off session lows after the Fed made a slight policy change to prevent its balance sheet from shrinking. As expected, no changes to rates were made and the Fed maintained that exceptionally low levels were warranted for an extended period. However, the Fed noted that with the pace of economic recovery more modest than previously anticipated, and to support further recovery, they will keep the balance sheet constant by reinvesting proceeds of principal payments from mortgage-backed securities into Treasuries. In other economic news, productivity unexpectedly fell, small business confidence declined and wholesale inventories rose more than expected. Treasuries moved higher after the FOMC announcement, but the 30-year reversed most of the day’s gain. Equity news was light, as MBIA Inc posted an unexpected profit, Nuance Communications Inc beat revenues, Scotts Miracle-Gro Co. beat earnings, and Netflix inked a content sharing deal with Epix to stream movies from Paramount, Lionsgate and MGM.

The Dow Jones Industrial Average lost 54 points (0.5%) to 10,644, the S&P 500 Index was 7 points (0.6%) lower at 1,121, and the Nasdaq Composite fell 29 points (1.2%) to 2,277. In moderate volume, 967 million shares were traded on the NYSE and 2.0 billion shares were traded on the Nasdaq. Crude oil fell $1.23 to $80.25 per barrel, wholesale gasoline lost $0.03 to $2.09 per gallon, while the Bloomberg gold spot price gained $2.90 to $1,204.25 per ounce. Elsewhere, the Dollar Index—a comparison of the US dollar to six major world currencies—rose 0.1% to 80.84.

MBIA Inc. (MBI $10) reported 2Q EPS of $6.32, well above the Reuters estimate of analysts, which called for the monocline insurer to post a loss for the quarter of $0.62 per share, driven by a sharp gain in the value of derivatives. Revenues came in at $2.08 billion. Shares were solidly higher.

Shares of Netflix (NFLX $125) were higher after the company inked a content-sharing deal with Epix, a joint venture of Lions Gate, Paramount and MGM to expand on Netflix’s streaming-video offerings. The terms of the five-year deal were not disclosed.

Nuance Communications Inc. (NUAN $15) was down sharply after the business speech, imaging and keypad solutions firm reported fiscal 3Q revenues of $273.2 million, which although rose 13% year-over-year (y/y), missed the Street’s forecast of $300 million. But the company said it benefitted from its healthcare and mobile business lines. NUAN also reported 3Q EPS of $0.30, one penny above forecasts.

Scotts Miracle-Gro Co. (SMG $47) reported adjusted fiscal 3Q earnings of $2.61 per share, above the $2.45 that analysts were anticipating, with revenues ticking 1% higher y/y to $1.24 billion, which was just shy of the $1.26 billion consensus estimate. SMG said its global consumer sales were supported by a 5% gain in consumer purchases at its major retail partners in the US. Shares were nicely higher after the results and after the lawn and garden products firm doubled its quarterly dividend to $0.25 per share and announced a $500 million share repurchase program. SMG also reaffirmed its full-year EPS outlook.

Fed changes stance, will keep balance sheet constant to provide support

The Federal Open Market Committee (FOMC) concluded its one-day monetary policy meeting by making no changes to the language with regard to the “extended period” for keeping rates at an exceptionally low rate and no changes to the fed funds target rate of a level between 0-0.25%. However, the Fed made a change in its policy with regard to its balance sheet, opting to keep the balance sheet constant by reinvesting proceeds from principal payments from agency and agency mortgage-backed securities into longer-term Treasuries. The Fed will continue to roll over Treasury holdings as they mature. With the balance sheet set to decline, essentially tightening the availability of money, the fed made the change in policy today to support the economic recovery, “in a context of price stability.”

In a separate statement, the Open Market Desk said it would target a level around $2.054 trillion for the balance sheet, by doing scheduled purchases at the middle of each month, and expects that purchases will begin August 17. The New York Fed, which conducts open market operations, will concentrate purchases of Treasuries in the two- to ten-year maturities, as well as TIPS securities.

Regarding its assessment of the economy, the Fed said that the pace of recovery in output and employment had slowed. However, the remaining language in the statement was generally unchanged, as the Fed said that consumer spending remains constrained by high unemployment, modest income growth, lower housing wealth and tight credit and that while business spending is rising, employers remain reluctant to hire. Additionally, the Fed continues to believe inflation will “likely to be subdued for some time.” The Fed continues to anticipate a gradual recovery, but that the pace “is likely to be more modest in the near term than had been anticipated.”

Thomas M. Hoenig was the lone dissenter for the fifth-straight meeting, who judged the economy as recovering modestly, as projected. He believes that the verbal commitment to low levels of the fed funds rate for an extended period is no longer warranted and limits the ability to adjust policy when needed and doesn’t believe that keeping the size of the balance sheet constant was required to support a return to full employment with price stability.

Treasuries jumped higher following the announcement, although the 30-year reversed most of the day’s gain. The yield on the two-year note fell 1 bp to 0.52%, the yield on the 10-year note lost 6 bps to 2.77% and the yield on the 30-year bond was flat at 4.02%.

Productivity unexpectedly declines and small business sentiment slips

Meanwhile, the preliminary reading on 2Q nonfarm productivity fell at a 0.9% annual rate, compared to the Bloomberg forecast of a 0.1% increase, and following the steep upwardly revised 3.9% increase seen in 1Q. This was the first decline in production since 4Q 2008, due to hours worked outpacing output compared to last quarter. Unit labor costs rose 0.2%, versus an increase of 1.5% that was estimated.

Elsewhere, wholesale inventories for June increased 0.1% month-over-month (m/m), below the 0.4% advance that economists had forecasted, and May’s 0.5% rise was unrevised. Inventories of durable goods rose 0.3% and electrical and electronic goods rose 2.4%. Meanwhile, stockpiles of nondurable goods declined 0.2% and farm product raw materials fell 4.7%. Sales dipped 0.7% in June, led by declines in nondurable goods and lumber and other construction materials, offsetting increases in motor vehicles and parts. The inventory-to-sales ratio—the amount of time it would take to deplete inventories at the current sales pace—increased from 1.14 months to 1.15.

In other economic news, the NFIB Small Business Optimism Index declined for the second month in a row, falling from 89.0 in June to 88.1 in July, compared to the expectation of economists, which called for the index to decline to 88.0. Similar to last month, the decline came as the number of firms reporting plans to hire remained weak and those expecting the economy to improve fell. Also weighing on the reading, firms planning to increase capital spending declined, along with components denoting easing of credit conditions and positive earnings trends.

Economic releases scheduled for tomorrow in the US are MBA Mortgage Applications, and the trade balance, expected to remain flat at a deficit of $42.3 billion.

Asia dominates international economic headlines

China’s trade surplus increased from $20.02 billion in June to $28.73 billion in July, compared to the $19.60 billion that economists had expected. The surprising increase in the Asian nation’s trade balance came as exports surged 38.1% compared to a 35% expectation, while imports rose by a smaller amount than forecasted, rising 22.7%, compared to the 30% increase that was anticipated. The weaker-than-expected import reading prompted some concerns about the strength of the Chinese economy, while the surge in exports caused some concerns that it may put pressure on the government to allow its currency to appreciate. The slower pace of imports may have also dampened the outlook for exports as many imports are used as inputs for future exports. Also, on a seasonally adjusted basis, Chinese exports declined slightly m/m in July. In a separate report, the pace of housing price increases slowed to 10.3% year-over-year in July, from 11.4% in June, and compared to the 10.5% reading that economists forecasted, while prices were flat month-over-month.

The other major economic event in the region came as the Bank of Japan (BoJ) kept its benchmark interest rate unchanged at 0.1%, as expected, and the BoJ noted that the nation’s economy showed further signs of a “moderate recovery.” Meanwhile, the BoJ disappointed some as it did not address the recent strength in the yen, which has posted an eight-month high versus the US dollar and is nearing the highest level in fifteen years, putting pressure on the outlook for profits of companies that rely on sales outside Japan. Elsewhere, a report on business confidence in Australia deteriorated to the lowest level since May 2009.

Meanwhile, data out of the UK dominated European headlines, as home prices unexpectedly fell in July, and retail sales in the area grew at a slower rate in July compared to June. Moreover, the UK trade deficit narrowed by a larger amount than expected. Elsewhere, French economic reports were disappointing, with separate reports showing June manufacturing production unexpectedly fell and industrial production posted a much larger-than-forecasted decline. Other reports in the euro-area included German consumer prices rising by a larger amount than originally forecasted, while wholesale prices in Europe’s largest economy declined.

International economic releases scheduled for tomorrow include Japan machine orders, UK employment, Brazil retail sales, Australian consumer confidence, and South Korean employment. China is scheduled to announce PPI, CPI, industrial production, industrial production, and fixed asset investment, while the release of money supply and new yuan loans are expected sometime this week. Lastly, the Bank of England will release its quarterly inflation report tomorrow.