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| COMMODITY REVIEW AND OUTLOOK
COMMODITY INSIGHT |
THE REAPER PRUDENTIAL SECURITIES, INC. |
195 Route 6A, Suite 6, Orleans, Massachusetts
(July 2, 1997) FINANCIAL INSTRUMENTS: BONDS–Sentiment regarding a rate hike seems to be changing to one of skepticism. While this market has been one that has easily lent itself to range trading, it may be that low inflation and moderate growth will keep the bonds in an upward track. Recent government reports would seem to bear this out.
RECOMMENDATION–Aggressive traders should continue to play the range. Sell September bonds in the 111.20-112.04 area, looking for a decline to the low 111.00's, possibly a bit lower. Consider reversing to the long side at that time. More conservative traders should wait to buy the low 111.00's with stops under 110.20 or of 32 or so ticks. Resistance lies near 112.04 and 112.24 Support may appear near 111.04, 110.20, and 110.12.
M. Steven Morgan Top
152 Ennis Lake Road, Ennis, Montana
(June 29, 1997) FINANCIAL INSTRUMENTS: The past six days of trading have been some of the most volatile days that I can ever remember for the equity markets– and in particular stock futures. In one recent three- day period the S&P fell $15,000 per contract but then rallied $15,000 a contract over the next three days of trading. It's no wonder stock futures are called pork bellies in pin stripes! That reputation is richly deserved.
Fortunately, the volatility in prices brought about a rally stiff enough to allow us to place shorts. On June 25, for instance, the September S&P rose to my selling level of 911.00. At that point, shorts in the September NYSE Composite should or could have been placed at 473.70, give or take a bit. That was the specific recommendation offered in the last issue of this newsletter.
Jerry F. Welch
P.O. Box 84901, Phoenix, Arizona
(June 26, 1997) FINANCIAL INSTRUMENTS: The Fed is unlikely to raise interest rates at the next FOMC meeting. Nevertheless, T-bonds, T-notes and Muni bonds have all stalled at expected resistance. This is partially due to overbought technical and psychological conditions. It is also due to weakness in the U.S. Dollar particularly against the Japanese Yen and British Pound, but also firming European currencies generally. I find particularly disturbing that the open interest has continued to decline in T-bond futures with the rally since mid-May. This is a sign of a weak market. Caution is advised. (Incidentally, the Rydex U.S. Government Bond Fund produces investment returns that correspond to 120% of the performance of long-term government bonds.) Investors are really strung up on debt, taking on risky Third World country debt. For example, the Russian Federation sold $2 billion of high-yield bonds. Expect volatility to pick up in stocks and bonds over the next couple of months. Bonds yielding four times stocks have led to some portfolio allocation shifts favoring bonds. September T-bonds have minor support at 110, strong intermediate support at 108, with resistance expected at 112.
RECOMMENDATION–Futures investors profitably long September T-bonds use 110-15 open protective stops to lock in profits. Futures investors profitably long September T-notes use 107-15 open protective stops to lock in profits. Futures investors profitably long September Muni bonds use 116 to lock in profits, Take partial profits if you have not already done so all positions.
R.E. McMaster, Jr. Top
One New York Plaza, New York, New York
(June 30, 1997) FINANCIAL INSTRUMENTS: INTEREST RATES–The Treasury market pulled back over the past week, as the market began to discount a number of risk factors. The initial setback was somewhat out of the blue: Japan's Prime Minister Hashimoto indicated that Japanese officials had contemplated selling off their holdings of U.S. Treasurys over the past few years during heated trade talks. His musings raised concerns about the level of foreign investment in the market. Subsequent efforts at damage-control were only mildly effective, largely because the market was not priced for any risk to the favorable conditions that have prevailed for the past few months.
LONG-TERM RISK: FOREIGN INVESTORS REDUCE HOLDINGS OF U.S. TREASURYS–It is worth a few minutes to focus on the level of foreign investment in the U.S. Treasury market, even though we doubt there will be any wholesale selling of those investments in the near term. Nonetheless, any shift in the demand curve for Treasurys due to either domestic or foreign reasons can impact the level of U.S. interest rates. Currently, 34.7% of all U.S. debt outstanding is held by foreign institutions or individuals. Of that total, Japan is the largest holder with $293 billion followed by the U.K. with $215 bil. The pace of foreign investment has accelerated sharply since the early 1990's, which has been quite positive for the U.S. As a net debtor nation, the U.S. needs to pull in foreign capital. If foreign investors' appetite for U.S. debt diminishes for any reason, rates would have to rise to a level high enough to boost domestic demand for Treasurys. That is, the savings rate would be forced higher by higher interest rates. Therefore, a strong dollar and relatively high interest rates are needed to keep foreign capital investment pouring in at a healthy pace.
The recent economic environment has been perfect for maintaining the inflow of capital. The U.S. economy has grown at a pace strong enough to keep interest rates well above those prevailing in Europe and Japan and the dollar has been rising steadily for two years. With inflation benign and the budget deficit declining, confidence in U.S. investments has improved as well. At some point, the situation will change. Most likely the change will stem from stronger growth and therefore higher interest rates abroad, which will make U.S. yields less attractive on a relative basis. It will also change as demographic forces shift. Japan and continental Europe have rapidly aging populations and their pension programs are hugely underfunded, Unfunded pension liabilities in Germany and France amount to about 100% of GDP while in Japan they are closer to 150%. (The UK, is the major exception with a relatively young population and virtually no unfunded pension liabilities.) As these countries need to draw on their own savings to fund the pension liabilities, they will undoubtedly turn to selling off foreign assets. So the long-term picture is problematical for foreign investment continuing to fund the U.S. markets. In 1998, we anticipate stronger growth abroad and a gradual rise in global interest rates. Beyond the year 2000, demographic factors could work strongly against the U.S. bond market.
SHORTER TERM: BUSINESS CYCLE RISK–The second risk factor for the market is the likelihood of stronger economic growth ahead. Even with last week's decline however, rates are not at particularly attractive levels given the risk of an upturn in the economy. The Fed has made it clear that they are closely monitoring the balance between supply and demand in the economy and any signs that demand is heating up to a level which could strain the ability of the economy to produce would be cause for a further tightening in policy. Hence, the key factor going forward is going to be the risk of a rebound in consumption. Right now, the market is not priced for that risk.
Last week's economic data hint at a rebound in the economy from the March-May slump. Consumer confidence soared to its highest reading since 1969. All of the components have risen, but the most significant is the future expectations component because that is the most closely correlated with consumer spending. The weekly retail department store surveys have indicated a pick up in consumption in June. In addition, existing home sales rose 4.8% in May signaling ongoing strength in the economy. Sales have been rising since late last year and the median home price is not nearly 5% above a year-ago indicating strong demand.
On the manufacturing side, the APICS survey indicated ongoing strength in the factory sector as did the Durable Goods report. Although the headline reading on durable goods was down 0.6%, the decline was largely due to a drop in the transportation sector reflect the month-to-month swings in aircraft orders and strike impact on auto makers. The underlying rate of durable goods orders was strong. Non-defense capital goods orders excluding aircraft are rising at an annualized pace of about 5.5% which is quite healthy and will contribute to strength in GDP. Unfilled orders for this category are also rising on a year-over-year basis. Next week's NAPM report is likely to confirm the strength in manufacturing, We look for the index to remain at the 57% level with new and unfilled orders still rising.
The other major reports next week are also likely to show strength. We look for the June Unemployment report to show the rate holding at 4.8% and nonfarm payrolls rising by 260,000. The weakness in the May payroll figure was largely due to seasonal factors. Those seasonals are expected to help the June number rebound. The overall trend towards strong employment gains is likely to hold until the labor market gets so tight that there are simply not enough candidates to fill jobs. Over the course of the past two years as the economy has strengthened, the labor force has grown at an astounding pace. It is only in the past year that wages have begun to turn higher, signaling tightness in some sectors of the labor market. Next week's report should show an increase in hourly wages of 0.4% which would put the year-over-year gain above 4%. There is a tendency for the June report to show a larger than average jump in earnings, so the risk is that the reading could be as high as 0.6%. Factory jobs should rise by about 10,000 and there should be ongoing strength in “other services” and construction. In all, we are looking for a healthy report on the labor market.
Auto sales figures will also be released next week. A moderate increase is likely for June after a decline in April and May. With strikes-related shortages resolved and favorable incentives, sales should rebound to a 13-million-unit pace consistent with good consumer fundamentals.With ongoing strength in the labor markets, rising real incomes and high levels of consumer confidence, spending is likely to pick up. The slowdown in the second quarter was probably just paying back for the huge jump in consumption in the first quarter. In addition, inventories remain lean and exports are rising at a double-digit pace due to strength in Canada and Mexico, which take the lion's share of U.S. exports. Given the natural tendency for the economy to expand the likelihood is that consumer spending will be on an upswing through the end of the year.
The Fed is unlikely to raise rates at next week's meeting, Having waited at the last meeting in anticipation of a Q2 slowdown, now that the slowdown has materialized, there is little reason for them to take action until they have a clear view of the second half. Moreover, the Fed appears to have changed course in the past year. Rather than taking a “preemptive” approach to policy, they appear willing to wait to see if inflation will pick up before taking action. This shift may reflect Greenspan's belief that productivity is understated and therefore that the economy can grow at a stronger pace than previously believed without generating inflation. It may also reflect a complacency about inflation overall. There seems to be a belief that any rebound in inflation will be slow and gradual and therefore, the Fed will be able to “catch up” quickly. Finally, Greenspan seems unlikely to raise rates ahead of the July 22nd Humphrey-Hawkins testimony given the difficulty he would face having to explain why the Fed raised rates just because the economy is doing well.
Longer term however, if we are right that the components of a strong second half rebound are in place, then the Fed will probably raise rates another 50 basis points by the end of the year. The market is clearly not pricing in that possibility. Two-year notes at just 50 basis points over the current funds rate allow no risk premium for tighter policy. We continue to favor defensive strategies going into the third quarter. With the potential for two more Fed tightenings this year, two-years notes could trade back up to 6,75% region while bond yields could move back above the 7% level.
Kathy Jones Top
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