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INTEREST RATE WATCH
Prepared by
R.J. O'Brien & Associates, Inc.
Global
The currency and stock market debacle in Asia has turned into a full-fledged debt crisis. This week South Korea commandeered center stage, as it became known that the $57 billion IMF rescue package was insufficient. The knowledge that there are probably more than $100 billion in international loans which will become due in less than a year sent the Korean Won reeling, and it fell more than 30% in three days before central bank intervention stopped the carnage. This currency panic and the resulting damage to the Korean economy have negative ramifications for our country. Not only is South Korea a valuable ally in the Pacific Rim, it is also our fifth-largest trading partner. (Last year it was one of the few Asian countries which ran a trade deficit with the U.S.). These reoccurring Asian difficulties are reinforcing fears that the U.S. economy will itself slow down, leading bulls to forecast much lower interest rates.
One bearish factor hovering over the market place is the fear that the Asian countries, driven by a desperate need for liquidity, would start unloading their massive holdings of treasury securities. This week, the Commerce Department reported (in its current account release) that foreign private investors slowed the pace of their purchases of U.S. treasury securities, buying $36.9 billion in the third quarter as opposed to $45.1 billion in the second quarter. Japan was a net seller, but their sales were offset by “a substantial step-up to record net purchases from Western Europe.”
The fact that foreigners are net purchasers is bullish in a time period when the dwindling budget deficit means a reduction in the supply of new treasury securities. However, these numbers are seemingly in conflict with the statistics we have been tracking from the U.S. Federal Reserve. As of December 10, 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 $627.306 billion.” Although there has been a net increase in foreign holdings of $9.498 billion in the last two weeks, the four-week average of total holdings has declined from its summer peak and the yearly growth rate continues to trend lower. Foreign purchases are only 2.3% over year-ago levels.
We don't understand the seeming discrepancy between these two sources, but it really doesn't matter, for domestic purchasers are more than making up for any shortfall in foreign purchases. This week the Investment Company Institute reported that mutual- fund investors are cutting back on their stock-fund purchases and gravitating toward bond funds. Investors put $13.5 billion into stock-mutual funds in November, 26% less than in October. At the same time, they added a net $8 billion to bond funds, more than twice October's $3.7 billion. It was the strongest move into bond funds since January 1994.
According to the Wall Street Journal, the best explanation for the slowdown in stock-fund buying is “continued nervousness about stock markets following the late- October correction. Turbulence in international markets–particularly in Asia–hasn't helped matters either...As for bond funds...investors view them as more of a sure thing.”
We'd never call bonds a “sure thing,” but there is a lot of investment money available to put into bonds. We have remarked many times that the U.S. money supply is growing rapidly (the M3 growth rate is at a ten-year high). This increase in the supply of money has riot led to an increase in inflation, because that increase has flowed into financial assets, especially stocks, and not to the general economy. To the extent that some of this money is now switching into bonds, it's a powerfully bullish force, and it is completely overwhelming the negative influence of a rapidly growing U.S. economy.
It's not as if the credit markets needed any reminder of the deflationary implications of the Asian economic turmoil, but this week the Bureau of Labor Statistics released the latest numbers for its import Price index. Led by a sharp decline in petroleum import prices (down 1.5% for the month and down 18.2% from last November), the import price index fell for the fifth time in six months. Overall, import prices have declined 3.9% from year-ago levels.
The markets also received good news in the form of the Producer Price Index, which fell by 0.2%. The decline in this index was also led by petroleum. In fact, in each of the finished goods, intermediate goods and crude goods sectors, the core inflation rate was higher than the overall inflation rate.
It's obvious that Asian financial difficulties and the strong dollar are working to keep the price of goods down. Given the fact that commodities make up such a large percentage of the official inflation rate (according to the BLS commodities and services comprise 42.87% and 57.13% of the CPI, respectively), this is bullish for bonds. However, we wouldn't get carried away–especially at these low yields–for there is nothing like low prices to cure low prices. Today's bargain prices will lead to lower supplies and increased demand by mid 1998, and that should mean a higher inflation rate.
We think the most bullish new this week was the sharp downward revision of the Federal Reserve's own Capacity Utilization Report. The downward revision means the Fed will be less afraid of industrial bottlenecks and the inflationary pressures that would result. It' another reason for the Fed to maintain the current level of short-term rates.
December 13, 1997R.J. O'Brien & Associates, Inc.
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