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U.S. ECONOMIC AND INTEREST-RATE OUTLOOK
Prepared by Merrill Lynch & Co.
International Fixed Income Research
The present read on domestic activity in the U.S. suggests a vibrant economy with just a few hints of emerging wage pressures. The impact of the events in Asia remain a big uncertainty however, and is likely to keep the Fed on hold.
Consumers are spending at a healthy pace. Although department store sales appear to have slipped in November, fundamentals such as income, confidence, and wealth suggest that spending growth will resume. The depressant from the stock market slide at the end of October never looked to be very powerful and is now likely to be wiped away by the rebound in the market.
Labor markets are tightening, and anecdotal reports of labor shortages are growing. Employers have been able to avoid allowing wage gains in excess of productivity, in large part due to competitive pressures, but it is questionable how long that can continue if labor demand continues to outstrip labor supply.
So under normal circumstances, the Fed would be ready to tighten policy. But the Fed is likely to view the fallout from the troubles in the Asian economy as having enough of a potential disinflationary effect to remove the need for a tightening, at least for now.
Developments in Asia should calm U.S. inflation pressures through two channels. The first would be the direct impact on exports: Asia accounts for about 30% of U.S. exports. Another consideration is the indirect impact of the troubles in Southeast Asia on the Japanese economy. Second, import prices, which have been declining for over a year, are likely to be pushed down further as a result of the Asian currency deprecations. Note that it will take several months before these effects begin to appear. For example, the effects of possible austerity measures in Hong Kong and Korea would take a while to unfold.
Martin J. Mauro
Fixed Income Trading Strategy
Several themes have dominated the bond market for the past few weeks that we believe will continue for the remainder of the year. First and foremost is the flattening of the Treasury yield curve as short rates rise and long rates drift lower. Second is the lagging performance of the mortgage market. The potential for an inverted yield curve serves to heighten investors' concerns as to the near-term outlook for the mortgage sector. The ARMs sector, in particular, is at risk in such an environment. Third is the recovery of the corporate market following the Asia crisis in October. The oversold conditions in corporates convinced investors that the sector offered strong relative value, and spreads on most corporates have recouped almost half of their spread widening since late October. In addition, Asian Yankee spreads have tightened anywhere from 10 to 30 basis points over the past few weeks. We believe the flattening of the 10-year/30-year Treasury yield spread will be supportive of the back end of the corporate credit curve.
William Cunningham
(Reprinted by permission. Copyright © 1997 Merrill Lynch, Pierce, Fenner & Smith Incorporated.)
December 3, 1997Merrill Lynch & Co.
International Fixed Income Research
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