Today's Morning Coffee - A Complex Rate Outlook

The market is tentatively awaiting the conclusion of the Federal Open Market Committee meeting today, but the result is widely expected to be no change in rates. However, the official statement could hold some dangerous term changes or indicate the direction of future action. Wall Street Greek believes an indication of some Fed governor minority wishes to raise interest rates could surface, and this would continue the summer swoon in stocks. However, we view a rather complex rate future in the medium term, and one which would soon include increasing expectation for rate cut, depending on the insight of the Fed.

Economic Data & Analysis

GDP Revision

First quarter GDP growth was revised higher to 0.7% from the 0.6% first estimated. However, the final reported rate of growth was slightly short of expectations for a 0.8% rise. Wall Street Greek believes our forecast is spot on regarding GDP this year. We were out in front with our view that Q2's pending pick up in growth would be followed by weakness in Q3 and Q4. We received the first confirmation of this view from an investment bank economist or strategist on June 22, when Goldman Sachs' Chief U.S. Economist, Jan Hatzius said, "Economic growth in the first half of 2007 is shaping up to look much stronger than seemed likely a couple of months ago. The caveat is that final domestic demand is softening, a development that could foreshadow a renewed slowdown later in the year.'' Sound familiar? Now think about when you first read that from the Wall Street Greek, and when the Street started reflecting that view. For the most part, the Street is still not anticipating a later slowdown driven by consumer softness, like we are. Think about the value add you gain from having that information significantly sooner.

Within the GDP revision, there was a more significant change. The inflation metric was revised higher to a 2.4% annual rate, up from the 2.2% initially estimated. Depending on the foresight of the Fed, this could significantly shake things up in the financial markets.

What to Expect from the Fed

With GDP growth expected to recover in the second quarter, depending on the Fed's outlook for consumer spending, they could look to make an impact on inflation in the short term. The argument against this is based on the recent rise of yields, effectively doing the Fed's job for them. However, Wall Street Greek believes the Fed would like to see long term rates edge even higher, once the housing market is stabilized. That's why I expect we will later find out that the Fed vote included some interest in raising interest rates.

Clearly, my view for an economic downturn later this year and next would advise a Fed cut, not a hike, but I wonder how evident this is to the Fed, since most economists still seem blind to it. The Fed itself has harped on the need to tame inflation over the past year. I've argued that the Fed may eventually find itself handcuffed with a weakening economy and rising inflation, otherwise known as stagflation, an ugly term and state of existence. Basically, the Fed would want to raise interest rates, but face the risk of driving significant recession by doing so. There may be no resolution in fact, and Bernanke's days as Fed Chief would be shortly ended.

So, this guides our view that the Fed will indicate interest in taming inflation, with votes. This would be a negative catalyst for stocks this summer. However, soon enough, we think consumer softness will make itself evident, and hope will intensify for Fed expansionary action. When/if this occurs, it might add some short term lift to the market, if the economy escapes recession or if it looks like it could be short-lived. We have to balance the reality of economic health, as well as expectations induced by Fed action, in anticipating market movement. It's a tough game to call, I think you can see.

Weekly Initial Jobless Claims

Weekly initial jobless claims at 313,000, came in below expectations for 318,000, while dropping from last week's total of 326,000 (revised). This is good news, but not significant enough to really matter. We continue to anticipate an increase in jobless claims will follow a drop in new hiring, so it's too early to look for signs of economic weakness here.

However, it's worth noting that Capital One Financial (COF) announced it would layoff 2,000 people as part of a cost restructuring initiative. Yes, this is that same Capital One that was willing to lend to everybody and their mother about a year ago. I'm not sure who could not see this one coming, but I think they should probably be taken out and shot to help improve the IQ of society.

Capital One announced a comprehensive plan to save $700 million pretax annually starting in 2009. The idea is to improve the cost structure of the company. It figures that if you run such a risky lending operation, you must do it bare bones in order to do it effectively. If I was managing that company, it would be the lowest cost operation in the business, outside of debt recovery mitigation operations, which would be top of the line. Still, that's no guarantee of survival, depending on how bad the consumer and employment environment gets.

We hope to provide an earnings roundup piece for you later today.

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