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INTEREST RATE WATCH
Prepared by
R.J. O'Brien & Associates, Inc.
Global
The effect of the Asian crisis on the U.S. economy has been modest, but it can be expected not to be negligible. (Federal Reserve Board Chairman Alan Greenspan)
The U.S. could benefit from eased inflationary pressure, but I'm not saying the disinflationary effects are severe or dominant. (Alan Greenspan)
Fed Chairman Greenspan tried to walk a fine line in his Congressional testimony, but the markets were much clearer in their assessment of the situation: “It really doesn't matter how strong the economy is right now, for the Asian currency and stock debacle is sure to slow the economy, thus relieving the need for the Fed to tighten.” As a result, investors are a little worried, and they are pouring into the long end of the Treasury market. You can see it happening in the Euro curve, which is beginning to invert, with the March '98 contract trading over the front month December '97 contract.
The inversion of the Euro curve is highly unusual. Take, for instance, the second and fourth contract months (currently, it's EDH8-EDU8, and it settled today at plus 11). We ran an historical study, and found that in the last five years, that spread has traded negative only 11% of the time. When it has traded negative, the average value has been negative 15 basis points (when it has been positive, the average value has been plus 46 basis points).
We must admit that it makes good sense: any economic slowdown in Asia resulting from currency and stock market declines can't be good for our economy. However, there is a tremendous amount of forward momentum existing in our economy, and by one standard, the future looks bright, indeed.
We like to watch the money supply aggregates; the more money sloshing around our economic system, the more likely it is that there will be vigorous economic activity. Yesterday, the Fed released its latest money supply numbers. For the three months ending in October, M3–the broadest monetary measure–has been growing at a 10% rate, while M2 has grown at a 7.3% rate. This is the strongest growth rate in over ten years. When considered all by itself, it would ordinarily ensure extremely strong U.S. economic growth well into next year. We believe it's way too early to tell how much the Asian mess will detract from that growth, so we consider purchases of longer-term maturities at these low yields to be premature.
Most analysts would agree that Asia's woes are responsible the bond market reaching its lowest yield since February '95, so it was ironic that Friday's rally was cut short by one possible implication of the trouble overseas. On Friday, the Nikkei stock index reached its lowest level since July '95, and rumors emerged of some type of bail-out plan for the Japanese stock market, including talk that the funds to support Japanese stocks might be raised by selling Treasuries.
Most analysts would also agree that a major reason for today's low yields is the failing U.S. budget deficit and the resulting decline in the new supply of U.S. Treasuries. By most accounts, the Japanese hold approximately one fourth of foreign holdings of U.S. debt, so if Japanese liquidation were to occur, there would be a sudden and substantial increase in supply, which would be quite bearish given today's high prices.
The latest data from the Federal Reserve shows no such liquidation. “On November 12, 1997, the face amount of marketable U.S. government securities held in custody by the Federal Reserve Banks for foreign official and international accounts was $628.315 billion, a change of plus $1.88 billion for the week. (The total includes the face value of U.S. Treasury strips and other zero coupon bonds).” However, the trend is clear. The four-week average of foreign holdings is the lowest since February of this year, and that average is only 5.09% over year-ago levels. In the last four weeks, a period in which the Asian currency and stock debacles regularly made front page headlines, foreigners liquidated approximately $7.5 billion of U.S. Treasuries.
The good news for the U.S. credit market is that U.S. investors are replacing foreign investors. The Journal reported on Friday that “several large mutual fund companies say that demand for bond funds is up so far this month in response to the stock market's volatility and the bond market's strength.” For the short run, we expect this equilibrium to continue. As long as the Asian troubles do not become appreciably worse, any liquidation of foreign holdings should be smooth and orderly. We also believe that the Asian problems will keep the U.S. stock market on the defensive, and that despite today's low yields, U.S. investors will continue to “tiptoe” into the U.S. bond market.
Fundamental
One reason U.S. investors have the courage to buy longer-term maturities at these relatively low yield levels is the complete absence of inflation in the U.S. economic scene. This week those investors received more good news. Producer prices in October inched higher by 0.1% and were down 0.2% from year-ago levels. The core rate remained unchanged. In addition, productivity skyrocketed at a 4.5% annual rate in the third quarter, and that followed a solid second-quarter gain of 2.4%. Due to this spectacular increase in worker output, businesses' true labor costs actually slid at a 0.3% rate in the third quarter, and over the past year they have risen only 1.3%. As a result, companies can raise wages without passing along the cost through price increases–or so the theory goes.
We have a few brief comments. Although producer prices for finished goods are down, the core rate is up 0.3% from last October. At the intermediate level, total goods are down 0.4%, but the core rate is up 0.6%. In contrast, at the crude level, total goods are up 0.3%, while the core rate is up 2.2%. Two things are obvious. One is that higher core prices are starting to move through the pipeline. Two is that lower food and energy prices are keeping the inflation rate down. That development will not last. Total goods at the crude level surge 4% last month, led by a 10.7% jump in energy prices. Bond bulls beware–we face a long run bull market in commodity prices over the next ten years. As for higher productivity, remember that we are a service economy. Brokers and department store clerks, for instance, can only talk to one customer at a time. We think productivity gains are overstated, and that they will be limited in the future.
November 14, 1997R.J. O'Brien & Associates, Inc.
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