ISM Data Suggests Rate Cut On Horizon

by: Thomas Kelly

With the seemingly never-ending stream of data coming down from Wall Street, sometimes it is useful to step back and take a look at the big picture. The ISM data that came out Monday is significant, because it showed the lowest reading we have seen since 2003. But how should we react to the data?

There are two real sides to this debate: 1) a recession is coming or; 2) the economy is slowing gradually. The February services number doesn’t help us very much in solving the debate, except if we look at in historical context. Therefore, I recommend investors use the link below to download historical ISM service data (under 'Business Activity'):

ISM Services Data

If you open the data in Excel and throw the last column into a chart, you get an historical time series of the ISM services index. As you can see from the chart, the ISM services data has been trending slowly downward from the 65 level since 2003. Far from this month being a radical decline, it is simply another step toward slower growth for the economy. There is no break point in the general trend, and it is well noted via the graph that the ISM data is volatile on a month to month basis.

It is also worth noting that the trendline of the ISM services index has now moved below 55 for the first time since 2003. This is important, because services had been leading the economy while manufacturing has been weak for the last two quarters. With services now approaching the 50 mark (below 50 represents a contraction), the Fed is much more likely to step in and cut rates to prop up growth.

When coupled with the very immediate crisis in the subprime mortgage market, I think we have all the cards on the table for a rate cut in June. The ISM services index is another critical piece of data here, especially because services comprise 80% of the U.S. economy. It is very clearly trending lower, and the trend has enough inertia that it can not be reversed in the course of 1 or 2 months. The Fed recognizes the need to be proactive, and therefore, I believe that they will see the need for a rate cut in June.

As for all the recent recession talk, the slow downward trend of the ISM data shows that the soft landing is still intact. Yes, we are getting into a dicey time period, and so the flight from risk makes sense, but if the Fed does cut rates in June, it is very likely that the ISM trend will begin to reverse itself in the third quarter. If that is the case, then U.S. equities will continue to be right, and buying the bottom of this correction will make 2007 very profitable.