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212-776-1000(March 13, 2000) FINANCIAL INSTRUMENTS: INTEREST RATES--OLD STRATEGIES FOR THE NEW ECONOMY--The Treasury market was range bound during the past week due to lack of fresh economic data. The market's resilience is impressive in light of the virtual certainty that the Fed will hike interest rates further in the weeks and months ahead. In fact, the ongoing flattening of the yield curve suggests the expectation that the economy will cool off before inflation accelerates. Yet these signals from the Treasury market seem at odds with the signals from the equity market, which suggest that there is a large segment of the economy immune to higher interest rates. At some point the two views will likely converge, but which is right? Is the Fed just tilting at windmills in trying to slow this economy with the old fashioned, blunt instrument of interest rates? Or is the slowdown inevitable?
HOW BIG IS THE E-ECONOMY?--A lot has been said about the way in which technology is changing the economy and, undoubtedly, the changes will continue. The signal from the stock market appears to be that the "old economy" is deteriorating while the "new economy" is growing rapidly. Technology stocks are rising rapidly while the vast majority of other stocks are weak. This divergence has led to the belief that the Fed's rate hikes will not slow the economy because e-commerce is less dependent on debt financing than companies in the "old economy." Yet, just how big is the new economy and is it really immune to the rising cost of capital?
In terms of size, it appears that the new economy is not as large as the headlines would suggest. The Commerce Department has attempted to measure the proportion of retail activity taking place on the internet or in electronic fashion. Their estimate was 0.6% of all retail sales, much smaller than private sector estimates and virtually insignificant in the broad scheme of things. The figures do not include all e-commerce, just the portion that is akin to retail sales in bricks and mortar stores. Hence, some of the higher private sector estimates are based on different methodology. Nonetheless, the overall figures are not very impressive.
Moreover, when it comes to the concept of the new economy sustaining the old economy as interest rates rise, the numbers don't appear to back it up. By my calculation, the number of jobs in the new economy is slightly less than 5% of total private sector jobs. The calculation was made by an industry breakdown with very generous assumptions. For example, everyone working in the manufacturing of electronic equipment and all communications workers were assumed to be in the new economy, even though that is an overstatement. In addition, a flat proportion of the service sector was added onto the category of technology services. Even if that estimate is wrong and we add another 5% for uncounted new economy jobs, it still appears that the overall level is small relative to the whole.
On the issue of whether new economy companies, because they have little or no debt, can escape the impact of higher interest rates, the evidence is not particularly clear. Nearly 40% of all capital goods orders in the past year were for technology equipment. Technology services are more difficult to measure, but appear to be growing rapidly as well. Rapid technological development along with the productivity gains associated with those changes should mean that demand remains strong. However, new economy companies are most often selling goods and services to old economy consumers and businesses. So, for example, a company selling high tech equipment or software services is still effected by the demand from old economy companies who have to finance or lease their goods and services. It may be a mistake to conclude that there is a segment of the economy impervious to the tightening in monetary policy. If demand slows in 90% of the economy, it would be surprising for it to remain strong in the other 10%. The implication is that the new economy has a long way to go before it eclipses the old economy. Since most of us live and work and derive our livelihood in the old economy, it seems likely that interest rates will have an impact on demand.
MONEY MATTERS--Ultimately, higher interest rates should translate into declining money growth. The money supply figures are beginning to show the impact of the Fed's efforts to drain liquidity from the system. M2 is now growing at a 4.1% annualized pace over the fourth quarter average which puts it within the 1% to 5% target band set by the Fed. On a year-over-year basis, it is running at a 5.9% pace. M3's growth rate is still above the 2% to 6% target band at 7.6%, but it is also falling from its peak levels of last year. Money growth peaked in March of 1999 in the U.S. and has been declining steadily since. Moreover, "free money" (money growth less nominal GDP) has been falling as well. That steady decline in excess liquidity is likely to lead to slower growth in the months ahead.
FED POLICY--It seems pretty obvious from the comments made by Greenspan and other Fed officials over the past month that they intend to continue to hike rates incrementally until the economy slows. I believe they will try to stick with a policy of 25 basis point moves because it is in many ways more effective. By raising rates 25 basis points and then threatening more rate hikes down the road, the market doesn't get a chance to assume that the "last rate hike" has been seen. Hence, the outlook continues to be "relentless but not aggressive" when it comes to the Fed.
Assuming it takes a premium of the Fed funds rate over the rate of nominal GDP growth to slow economic activity, we would anticipate a funds rate of about 6.5% is reasonable. That translates into three more 25 basis point hikes. However, this rule of thumb is just about as inadequate as any other in pinpointing the peak in the funds rate for the cycle.
THE WEEK AHEAD--Next week, there will be a slew of major economic reports released. The week will start out with retail sales which should rise a strong 1% overall and 0.7% excluding autos. The surge in auto sales as well as higher gasoline prices and generally strong consumer spending should translate into a large gain. Industrial production figures for February will most likely post a healthy 0.4% gain while capacity utilization probably edged higher to 81.7%. PPI is expected to rise by 0.6% overall due to strong energy prices but a more moderate 0.2% excluding food and energy. Housing starts will most likely show another decline due to the impact of higher mortgage rates. Overall the market is going to have to contend with strong economic data in the week leading into the next FOMC meeting.
MARKET OUTLOOK--The overall Treasury market appears vulnerable to a pullback in the weeks ahead. The combination of strong economic data and the likelihood of more tightening by the Fed should keep pressure on prices. However, given the fact that the Fed is tightening policy in a low inflation environment, the yield curve should continue its trend towards flattening and inversion.
Kathy Jones
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