Kevin Spires, CFA, FRM

The ISM Manufacturing Survey results were reported this morning and the composite was 49.8 for July versus 49.7 in June. 

New Orders also dipped below 50 for the first time during the recovery at 48.0.  This is a bit ominous as it implies a contraction in Industrial Production growth could take hold in the next quarter or two.  The European Crisis and the looming fiscal cliff in the U.S. are causing weakness to seep into the Manufacturing Surveys.

I am a bit doubtful that this weakness will translate into a broader slump (based on employment, housing, and liquidity indicators), but the sharp contraction in new orders, if extended, would be a strong piece of evidence that a deeper slump was imminent.

Kevin Spires, CFA, FRM

The ISM Manufacturing report was released at 10:00 am EST today.  It was much worse than expected, with the Composite falling to 49.7 from 53.5 last month (50 is expansion/contraction threshhold).  New Orders plunged over 12 points from 60.1 to 47.8.  Employment was the lone bright spot, dropping slightly from 56.9 to 56.6.

With the plunge in the New Orders sub-component, Industrial Production growth is likely to stall in the coming quarter.  Looking at the trend in New Orders, there have been lower highs and lower lows each year going back to the start of the recovery in 2009.

This is another data point that will cause markets to build in expectations of QE3.  I believe that Bernanke wants to print more money, but he is hesitant to do so without a longer string of weaker data. 

Kevin Spires, CFA, FRM

Industrial Production dropped by .1% in May after a 1% increase in April.  Industrial Production growth should continue to be reasonably strong as shown by the relationship between the ISM Manufacturing New Orders sub component and the Q/Q growth in Industrial Production in the chart to the left.

Click on our full Manufacturing Chart Package

Kevin Spires, CFA, FRM

Industrial Production rose 1.1% in April after a downwardly revised -0.6% in March.  Capacity Utilization rose to a post-recession high of 79.2%.

The first thing to note is that the ISM New Orders Index is a good proxy for Q/Q changes in Industrial Production.  Current ISM New Orders of 58.2 are consistent with Industrial Production Growth of 1.5 - 2.0% Q/Q or 5-7% annualized.  Current data is moderately strong and does not show any signs of imminent collapse.

Given the growth rates in Industrial Production, Capacity Utilization has been growing as well.  With close to 5% growth rates in Industrial Production over the past 12 months, Capacity Utilization was up 2.67%.  Given the Expectations for Industrial Production to remain in the 5-7% growth range going forward, Capacity Utilization will probably grow by at least another 2-3% over the next 12 months.

The Key point to take away from this analysis is that Industrial Production and Capacity Utilization are growing at rates that will put Capacity Utilization in the range that is normally associated with normal to tight Fed Policy.  In this context, the current Zero Interest Rate Policy by the Federal Reserve is looking less and less tenable. 

The longer the Fed takes to normalize policy, the higher and faster that interest rates will ultimately have to rise to conteract rising inflation.  Call me a hawk on this one, but I am just judging the Fed against a policy reaction function, that in the past two interest rate cycles, caused two massive bubbles to arise - first the Internet Bubble and then the Housing Bubble. 

I wonder what Bubble will end up bursting this time around - because the Fed has fallen behind the curve once again.  I am pretty certain that a Bubble has been formed in the Social Networking sector of the Internet and I expect the current overly accomadative Fed Policy to cause massive dislocations in Credit, Currency, and Commodity markets going forward.  As the Fram Oil Filter commercial used to say "You can pay me now, or pay me later." 

Kevin Spires, CFA, FRM

During its twice quarterly FOMC meetings, the Federal Reserve releases a statement that explains why it has the monetary policy that it does.  Quoting the FOMC statement, "In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions-including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014."  Now, most of the focus on low rates of resource utilization is on the Unemployment Rate which is currently above 8%.  In this post, I am going to focus on the other aspect of resource utilization - Capacity Utilization from the Federal Reserve's G17 Report.

Currently, Capacity Utilization stands at 78.6% for all industries and at 78.3% for Manufacturing.  Why is this so important?  Because, with the current rate of capacity take up, Capacity Utilization Rates will be greater than 80% by the end of 2012.

Historically, the Fed has started raising interest rates when the Capacity Utilization rate has been between 80-82%.  In February of 1994, Manufacturing Capacity Utilization was at 81.4% before the Fed first raised rates.  In early 1999, Capacity Utilization was barely 81 -82% when the Fed started the tightening that killed the Stock Market Bubble.  In 2004, Capacity Utilization was actually below 80 when the Fed started "normalizing interest rates."