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The economy and the fixed income markets: Must-know latest updates

The economy and the fixed income markets: Must-know latest updates (Part 1 of 11)

Why Chicago’s manufacturing sector is no more a market concern

Manufacturing in the U.S.

Manufacturing has always remained at the center of the U.S. economic growth. Other things being equal, growth in the manufacturing sector essentially drives higher production of goods, which leads to increased requirement of skilled and unskilled labor and a steady supply of raw materials for production. When the employment level increases, it brings a plenitude of opportunities for an economy, but most importantly, it drives the demand for goods and services. This will eventually lead to inflation, obeying the law of supply and demand. In financial markets, particularly in the case of the bond market, understanding the repercussions of inflation and subsequent impact on market interest rate (the Fed funds rate) is very essential for investors to make an informed investment decisions. This series focuses on the major macroeconomic indicators released last week (March 24-26) and their implications on both U.S. equity and bond markets.

On Monday, March 24, 2014, the Federal Reserve Bank of Chicago released the manufacturing data for the month end of February 2014. The index indicated a positive comeback after two months of poor manufacturing data, which was impacted by severe weather conditions. Production and income, higher sales, order, and inventories drove the index growth.

Chicago Fed National ActivityEnlarge Graph

The Chicago Fed National Activity Index (or CFNAI)

The CFNAI is a monthly index designed to gauge the overall economic activity and inflationary pressure in a better manner. Released toward the end of each calendar month, the index is a weighted average of 85 monthly indicators of national economic activity. It is constructed to have an average value of zero and a standard deviation of one.

What did the latest reading indicate?

On a composite level, bullishness prevailed at 0.14 reading compared to January’s revised -0.45 reading. The growth in index was capped by a decline in the consumption and housing component, which eased off slightly but remained negative at -0.16, up from -0.19 for January. The consumption and housing component has been declining in Chicago continuously from past seven years now. The employment component dipped to -0.02 from a positive 0.11 in January. The production component rose to 0.26 compared to -0.38 during the severe cold of January. Sales/orders/inventories made a positive comeback at 0.06 level from January’s zero level.

Market reactions

The index is highly correlated with the overall change in the U.S. economic conditions. When economy tends to move upward, the index shows a positive reading (a case of this week releases) which corresponds to growth in the economy, positively impacting operating performance of companies, thereby driving up valuations, and in turn, stock markets (SPY). However, bond market (BND) reacts negatively if, with economic growth, the inflation increases, prompting central banks to increase interest rates. As bond prices and interest rates share an inverse relationship, bond prices decline when the interest rates rise.

The index reflects financial and operational ability of some of the major manufacturing and industrial companies operating in Chicago. Some of the companies operating in the area such as General Electric Company (GE) and United Technologies Corporation (UTX) are constituents of the Industrial Select Sector SPDR (XLI) ETF. The index has posted 29.5% returns over the past one year. Fixed income investors can track iShares Industrials Sector Bond Fund (ENGN), which comprises 56% of the U.S. corporate bond market and has top holding in Verizon Communications (VZ).

Move on to the next part of the series to know how manufacturing activity fared in Richmond city.

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