wmeubank@ocp.kcmo.com
INTEREST RATE WATCH
Prepared by
R. J. O'Brien & Associates, Inc.
Global
We've been completely surprised by the most recent rally in bonds. Even given the assumption that the Asian problems will substantially slow the U.S. economy, it seems to us that bond yields are up in the “nosebleed” reaches of the stratosphere.
One way we try to measure “value” is to compare the latest yields to the (daily) average during the Clinton Administration. We pick these last five years as the measuring stick, because it has been during this period that Democrats and Republicans alike finally got serious about addressing the problem of the U.S. budget deficit. You could say that from 1993, a fundamental shift has occurred in our economy: therefore, it doesn't seem to make sense to use earlier periods for a comparison.
Using these yardsticks, it is hard for us not to conclude that bonds are overvalued. T-bond yields are 56 basis points over the Fed Fund rate compared to the average of 212 points. The spread between 3-month bills and 30-year bonds is 91 basis points compared to an average of 230. Finally, the current real yield of bonds is 3.96 (using the latest year/year CPI rate of 2.1%) compared to the average of 4.09%. In contrast, the real yield of the 3-month bill is now 3.04% compared to the average of 1.78%.
The high real yield of T-bills is leading some bulls to believe that the Fed should reduce short rates. There were a number of reports this week, and on balance they suggested that U.S. economic momentum might be slowing, thereby adding credence to bullish arguments. However, it seems to us that the forward momentum of the U.S. economy is still strong enough to preclude any such action in the near term. So until the financial downturn in Asia begins to seriously crimp U.S. economic activity, the Fed will not reduce short rates. In the absence of any such action, we think the yields of longer term maturities are too low.
Bullish investors had to be cheered by the mild 0.2% rise in the Consumer Price Index. The 2.1 % yearly rate is the lowest in over ten years. However, before investors get too carried away, they should consider the implications of these facts, One, the Bureau of Labor Statistics has been working behind the scenes to arrive at a lower CPI figure, and next year they will adopt an experimental measure which will bring the inflation rate even lower. So when comparing today's real yields to those of prior years, remember that today's real yields are inflated by a method specifically designed to reduce the inflation rate.
Two, at this time a year ago, we were well on our way to a 3.3% yearly CPI however, the market was supported by the fact that the core rate was significantly lower. Today, the core rate of 2.3% is higher then the overall 2.1 % rate. Note that inflation in the service sector, which makes up 57% of the CPI is up 3%, while commodities are up only 1%. In 1998, higher commodity prices should have the opposite effect.
Finally, housing makes up 41.3% of the CPI index. Frankly were a little skeptical that the housing component of the CPI index is up only 2.4% over last year. When you consider that the cost of buying a new home is accelerating (average and median existing home prices are up 6.62% and 7.12%, respectively), and when local real estate taxes seem to rise 5% each and every year, you have to wonder just how accurate the new, “more accurate” CPI really is.
Bulls also received good inflation news in the form of the Capacity Utilization Rate, which rose 0.1 in October to 84.3%. This is the highest level since March 1995, so the Fed must be concerned about its upward trend. However, the market was buoyed by the fact that the September rate was revised lower, and the October rate was significantly below expectations.
Perhaps the most bullish piece of inflation news concerned the Import Price Index, which rose 0.1% in October to 97.9. Although this was the first increase in ten months, the year-over-year rate declined further, and prices for all imports are 3.83% lower compared to October, 1996. Given the currency devaluations throughout all of Asia, import prices will no doubt be pushed lower still.
Tying right in with the decline in import prices was the 17% monthly increase in our September trade deficit (although the August trade gap was revised lower by 8.6%). Imports, at a record $89.1 billion, shot up 1.2%, while exports at $78.0 billion, were down 0.7%. The obvious conclusion is that the strong U.S. dollar is starting to hurt our export growth, and the implication for the future is that the Asian economic turmoil will cause a further flood of cheap imports and a marked slowing of our exports. However, we wouldn't rush to such a rash judgment. Despite the heretofore strong U.S. Dollar, U.S. exports are up a vigorous 10.74% over last September, while U.S. imports up only 9.52% over the same period. Thus, at this time, our export growth is stronger than our import growth.
Another misconception arising from the economic problems in Asia is that investors worldwide will flock to our markets for safety. It hasn't happened yet. In the latest week, ending Wednesday, foreigners liquidated $2.5 billion of U.S. treasury securities.
Finally, the 0.7% increase in September Business Inventories, combined with October's 0.2% decline in Retail Sales, has to make one wonder whether U.S. consumer spending is slowing. Is the buildup in inventories voluntary–a premeditated effort to get ready for a strong Christmas buying season? We're not especially concerned, for the financial well being of the average U.S. consumer is quite strong. Real hourly and weekly wages are 2.29% 2.53% higher than a year ago. We don't believe the U.S. economy will slow any time soon.
November 21, 1997R. J. O'Brien & Associates, Inc.
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