National Futures and Financial Weekly

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Copyright 1997 by Consensus, Inc.
May 09, 1997 * * 1737 McGee, Kansas City, Mo. 64108 U.S.A. * * Up Dated Daily

For seventeen months, both investors and the monetary authorities have worried that above-trend economic growth will eventually result in higher inflation. This concern has generated two distinct jumps in long-term interest rates, one of which was accompanied by an increase in the Fed-determined overnight funds rates. Anxious about fast economic growth in early 1996, investors pushed the 30- year Treasury bond yield from 5.92% in January to 7.25% in July.

During that period, however, the central bank kept the funds rate stable at 5%. When the business pace slowed in the third quarter of 1996, the yield on the 30-year fell to an early December low of 6.31%. From that point, a second bout of inflation worries unfolded. Observing above-trend growth in late 1996 and early 1997, investors pressured the bond yield up to its recent April 11 high of 7.18%. To some extent, this latest rise was bolstered by the Fed's decision on March 25 to increase the funds rate to 5<$E1/2>%. It should be noted that, throughout this 17-month period of wide swings in long-term rates, inflation as measured by the CPI remained stable at 2.7%.

After this anomalous experience, investors now face three questions in forecasting the intermediate-term path of the 30-year bond yield:

1. Are the concerns about future inflation misplaced? Can the economy grow faster than the assumed trend-rate of 2.0%/2.5% without intensifying the pace of price increases? How does the Fed view this issue?

2. What is the likely path of growth during the rest of 1997?

3. Will the expected benefits of the balanced budget agreement offset cyclical influences and foster a decline in long-term interest rates?

Economic Growth And Future Inflation

Many pundits argue that, even if there was a causal relationship in the past, currently there is not a tight linkage between above- trend growth and inflation. These observers cite three reasons. New technologies have increased the economy's capacity to expand. The increasing globalization of production has introduced competitive pressures which restrain domestic inflation. And, persistent job insecurity has suppressed and will continue to suppress wage demands.

Indeed, in this business cycle, these factors have worked to keep wage pressures and inflation lower than the level implied by historical experience. However, there are two reasons to expect that these salutary influences will now diminish. First, at the current low unemployment rate of 4.9%, there is substantial evidence of shortages of both skilled and entry-level labor. The conditions are ripe for job insecurity to wane and wage demands to accelerate. Recent pay hikes and wildcat strikes in the auto industry testify to this development. Second, service industries are to a large degree insulated from foreign competition, and their products comprise over one-half of the CPI. When faced with labor shortages, these businesses will not feel constrained from paying up for workers and passing the costs on to consumers. Such a development would surface quickly in higher CPI readings. The public statements of Fed officials indicate that they endorse this latter argument. They believe that the labor supply is now strained and that continued fast economic growth will aggravate inflation.

The Economy's Path During The Remainder Of 1997

While the pace of GDP growth should certainly slow from the torrid 5.6% rate of the first quarter, it should remain above the assumed trend-capacity of 2.0%/2.5%. With the exception of the trade sector, the economy carried strong forward momentum into the spring. Present conditions should not impede this momentum.

Personal income is growing at a rapid 6.5% annual rate; inventories are not burdensome; and new business investment is robust. In this environment, over the next 8 months the economy should grow much closer to 3.0% than 2.0%. Given this expected outcome, the Fed should raise the fed funds rate an additional 50 basis points over the remainder of the year. However, the next rate increase is much more likely in July than at the May 20 policy meeting.

The Influence Of The Balanced-Budget Agreement

Other issue aside, the 5-year plan to balance the federal budget should moderately depress long-term interest rates. Investors should take heart from this political commitment and infer that reduced government borrowing will lower yields. However, substantial skepticism about the details of the agreement should limit this influence. Investors are likely to question the revenue assumptions of the plan which require continued fast economic growth for the next five years. Investors should also notice that the pact is very vague in how growth in entitlement expenditures will be cut. These shortcomings should retrain an overly optimistic reaction to the agreement.

Conclusion

The answers to these key questions reveal mixed influences on long- term interest rates. Consequently, over the next two months, the 30-year Treasury Bond should fluctuate in a trading range. We forecast that this maturity will both test and hold at an upper 7% boundary and a lower 6.65% boundary. For the lead contract of bond futures, this equates to an approximate range of 108-12 to 113-00.

May, 1997
Dean Witter, Inc.
150 South Wacker Drive, Chicago, Illinois

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