PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
212-778-1000
(March 27, 2000) FINANCIAL INSTRUMENTS: INTEREST RATES--MR. GENSLER'S WILD RIDE--Last week, for the first time since early January, the bulls appeared to lose control of the runaway Treasury bond market. The bond market, which has seen yields drop an astounding 80 plus basis points in two months, finally appeared to stall. Yields edged lower early in the week as the Fed's 25 basis point hike in the Fed funds rate appeared reassuring to a well-prepared market. Then the Treasury surprised the market with talk of removing support from the agency market which was well on its way to supplanting the Treasury market on the supply side. Concerned that there would be no quality bonds left to trade, Treasuries rallied sharply mid-week, causing credit spreads to widen to unfathomable levels. By the end of the week however, the market was on the defensive when the FOMC minutes indicated that some Fed officials want to take a more aggressive stance on policy.
Perhaps the volatility in the market was a function of the lack of real economic news. With a light data calendar, market participants let other issues become important. The only reports released were January trade figures which were horrendous and durable goods orders were which weak for the second consecutive month. Neither was a big surprise to the market however. The trade outlook has been deteriorating for well over a year and there are no signs of an imminent turnaround. The durable goods data suggests that the factory sector is cooling off after the Y2K related surge of the past year, but in general the pace is still healthy. About the only implication is in Q1 GDP where strong consumer spending will be partially offset by the deterioration in trade and a moderating trend in the industrial sector. The economy however still shows signs of growing at a pace in excess of what the Fed believes is sustainable without generating inflation. That remains the key for the market.
OF AGENCIES AND SPREADS--Mid-week the market was jolted by comments from Under Secretary of the Treasury Gensler who was testifying before Congress about the Treasury market. In his testimony, he indicated that Congress might consider cutting the credit lines it has established for the Government Sponsored Enterprises (GSEs). The agencies are Freddie Mac, Fannie Mae and the Federal Home Loan Banks. Congress maintains nominal credit lines for these agencies in the event of a funding emergency. The Treasury's concerns stem from the increasing popularity of the agency's debt paper as a replacement for U.S. Treasury securities. The agency paper is not backed by the full faith and credit of the government as Treasury securities are, but with AAA ratings and the implicit support of the Congress, they are viewed as the next best thing. The "moral hazard" problem could arise in theory, since the government would probably take it upon themselves to bail out these agencies should they run into trouble.
As a result of his testimony, the spread between Treasuries and agencies expanded sharply. In fact, the spread reached levels not seen since the Russian debt default in 1998 when there was a flight to safety into the Treasury market. This time around, the market was pricing in a higher risk premium for the agency paper and at the same time bidding up for treasuries as a scarce commodity. In reality, the likelihood of Congress changing the rules of the game for the agencies seems pretty slim, certainly in the near term. The agencies have never run into trouble and they were created by Congress to fill a need. Hence, it seems unlikely that there will be a rush to fix something that isn't broken. However, the market has to price in some probability of that happening, no matter how small. At a minimum, it appears that credit spreads will remain highly volatile for the foreseeable future.
THE FED: HOW MUCH AND HOW SOON?--Just as the market began to stabilize after the Gensler scare, the minutes of the February 2nd FOMC meeting were released. The report was expected to be a non-event since the result of that meeting and the one earlier in the week were already known. However, the minutes indicated that a "few" members at the February meeting argued in favor of a 50 basis point hike in rates rather than 25 basis points. In fact, the report indicated that "Other members acknowledged that the Committee might need to move more aggressively at a later meeting..." The revelation caused the short end of the yield curve to sell off sharply, pricing in the greater risk of a larger rate hike in the months ahead. The fact that the FOMC did not hike rates 50 basis points at the February or March meetings seemed to have little impact on the market.
The real question is how high do rates have to go to slow the economy? There is a pervasive belief that the economy has so much momentum and is driven by such magnificent returns on investment that slowing growth will be extremely difficult if not impossible. Clearly the economy does have strong forward momentum. Yet, it is also clear that there is some level of interest rates which will slow down economic growth. The real question is how high do rates have to go and is the Fed willing to push them to that level?
I am in the minority in believing that the market is probably under estimating the power of monetary policy. The cumulative 125 basis point rate hikes to date have not slowed economic growth, but it is really early days for this cycle. The first three rate hikes in 1999 simply reversed the three rate cuts in 1998. So, the liquidity cycle just got back to zero recently. It's not surprising then that the yield curve didn't invert significantly until the fourth rate hike was approaching. That's when Fed policy got serious. There are "long and variable lags" in the implementation of monetary policy. Think back to the easing cycle in the early 1990's when the Fed kept cutting rates but the economy seemed unable to respond. Then think about 1994 when the Fed was hiking rates and nobody believed the economy or inflation would ever cool off. It takes time and every cycle is slightly different but money matters. Money growth in the U.S. peaked in March 1999 and has been gradually decelerating ever since but the rate of growth in the monetary base spiked up late last year because of Y2K. It might take a while longer for the decline in liquidity to work its way through to the economy.
As a rule of thumb, the Fed funds rate usually needs to exceed the rate of growth in nominal GDP before the economy cools off. It would take a 6.5% Fed funds rate to reach that level, or another 50 basis points in tightening. Another indicator is the "real" fed funds rate which measures the tightness of monetary policy. Currently, the "real" fed funds rate is already at the highest level since 1990 and well above the average which has prevailed in the 1990's. (Figure 1). For the purposes of simplicity, the real funds rate is calculated using the current rate of core inflation subtracted from the current funds rate. Both measures suggest that policy is likely to have some impact, particularly if the funds rate hits 6.5% or higher. While there is a risk that they begin to move more aggressively at the next meeting, it isn't a high probability. After all, they have stayed with the incremental policy stance to date, despite the discussion of larger rate hikes.
Figure 1
Real U.S. Federal Funds Rate
(percent)
Source--Haver Analytics
The key to slower growth will be a moderating trend in consumer spending. By extension, it is apparent that the strength in the stock market and the wealth created by the huge rise in equity prices, is keeping spending strong. However, year to date, the Wilshire Index, which is the broadest measure of stock prices and therefore the one followed by the Fed, is up about 3% after several years of double-digit increases. It is the first time in five years that the Wilshire is not rising relative to income growth. All this means is that if stock prices broadly hold steady, consumers are likely to be a bit less giddy in 2000 than they have been in the past few years.
THE WEEK AHEAD--In the week ahead, the economic calendar remains fairly light. Existing and New Home Sales data will probably show further weakness in the sector while consumer confidence has probably edged lower. Q4 1999 GDP revisions will probably continue to show that last year ended with strong momentum, but that is old news at this stage. The week rounds out with personal income and consumption data, which will probably be strong and show further declines in the personal savings rate.
Elsewhere, there is the OPEC meeting on Monday. The market is anticipating production increases and lower prices down the road, but there is some uncertainty about the outcome of the meeting.
MARKET OUTLOOK--The market has had a good run from the lows and is probably overdue for a correction or consolidation. I am solidly in the bullish camp longer term in the bond market, but given the uncertainty about policy and the ongoing strength in consumer spending the risk near term is for a pullback. I continue to look for the curve to remain inverted and bond yields to work lower longer term. Our longer-term view is that as growth moderates and inflation abates in the months ahead, bond yields have another 50 basis points to fall from current levels. Real growth at 3.5% combined with 2% inflation would leave fair value at roughly 5.5%.
Kathy Jones