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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(August 11, 1997) FINANCIAL INSTRUMENTS: The Treasury market posted another huge decline during the past week, sending bond yields back above 6.66% on Friday and steepening the yield curve. Bond yields are now back at pre-Humphrey Hawkins levels. Since there was little solid economic news released during the past week, it is worth taking a look at what is really happening,
First off, the rally from April to July was based on the markets' willingness to believe that 1) the economy was slowing to a sustainable pace 2) that inflation would continue to fall from Q2 levels 3) that the Fed's next move will be an easing and 4) that the budget/tax deal out of Washington was meaningful for the bond market. The peak in July nearly matched the one in December of last year to the tick and was driven by the same sorts of factors. The post election euphoria promised a balanced budget and the economy appeared to be cooling off. Of course the market fell apart then too just as it is now,
BOND AND BUSINESS CYCLE STILL ALIVE–There is a fairly obvious cycle in both the economy and in the bond market right now. GDP growth tends to run strong for two quarters and then slow for one quarter. The bond market seems react to these fluctuations in the growth rate with a lag. Yet, the fact of the matter is that the economy has been and continues to grow at a fairly healthy rate close to 3% and has for the past few years. The temporary setbacks in GDP growth seem to always elicit the belief that the economy is moving to a sustainably slower pace. Then growth rebounds and the bond market tanks. Every time the market approaches the old highs, there is a new reason such as the belief that global overcapacity will produce deflation or rising energy prices will prove to be a “tax” on the economy or devaluations of South East Asian currencies will cause a steep drop off in global demand.
All of this seems to ignore that the economy's tendency is to grow and the Fed has accommodated that growth quite nicely over the course of this business cycle. In fact, the Fed funds rate at 5.50% is still relatively accommodative if one looks at it relative to the trend growth rate in nominal demand or relative to the real cost of capital, In fact, in order to stay neutral or become more restrictive, the Fed would have been raising rates more aggressively this year. Clearly the boom in the economy and in the stock market, driven by rapid investment in technology has reflected a high real return on capital provided by a fairly easy Fed.
On the consumer side, there is far less reason to expect a slowdown in 1997 than there was two years ago. Consumers have gradually reduced their debt service burden. Compared to two years ago, the growth rate in consumer credit is much slower. Moreover, employment and income growth is strong and the stock market was booming prior to last week's decline. Many of the leading indicators of consumer spending remained strong during the Q2 “slowdown.” Housing activity and demand for services were quite healthy.
Finally, the market ignored the strengthening in the Canadian and Mexican economies and the positive impact that continues to exert on the U.S. The Americas are collectively growing at the fast rate in a decade, something that should continue to propel GDP, employment and exports going forward. All of this is to say that a sustainably slower growth rate is unlikely until the Fed raises interest rates further. So when the inevitable talk of a slowdown occurs in the first quarter of next year, consider whether the Fed has really done anything to cause a slowdown.
INFLATION: STILL LOW, BUT NOT LIKELY TO FALL FURTHER–One of the factors boosting the market over the past few months has been the sharp decline in wholesale inflation. Much of the decline was due to failing food and energy prices along with the ubiquitous decline in computer prices. Food and energy are notoriously volatile and since July 7th, they have been moving sharply higher. As the next set of PPI figures approaches next week, it is likely that the downward trend in PPI will most likely have ended. Although we don't look for rampant inflation at the wholesale level, it is likely that the drop off due to these factors will have ended. Meanwhile, prices for industrial goods have continued to strengthen. They never really fell very much during Q2 but in Q3 they have picked up sharply. The Journal of Commerce index is up 4.8% in the past month alone.
On the consumer side, there continues to be a dichotomy between the cost of services and the cost of goods, especially durable goods. Service sector inflation is gradually rising and has even accelerated in the past few months while the cost of durable goods, especially autos and computers, continue to fall. The logical explanation is that where there is global competition, costs are contained while in services where competition is not very high, costs are rising.
All of this is to say that next week's inflation data, although not likely to be particularly bearish, are unlikely to be all that helpful to the market. PPI most likely will break its string of month to month declines and rise a modest 0.1% overall and 0.1% excluding food and energy. CPI is likely to rise 0.2% overall and 0.2% excluding food and energy. In the long ran, inflation is driven by excessive demand driven by accommodative monetary policy and that is why the news going forward is likely to be less friendly than the news over the past few months,
DEMAND STILL STRONG–Perhaps the most negative aspect of the past few days has been the market's recognition that consumer demand has bounced back in the third quarter. The sharp rebound in auto sales in July to a 13.4 million unit pace caught the market by surprise. It is the highest selling rate since the peak level in March and well above the 12.3 million unit pace seen in June. In addition, chain store sales rose about 5.5% in July, up from the more tepid 2.4% pace in June.
In the week ahead, the focus will be on the retail sales data despite the fact that the report is arguably one of the most error-ridden and heavily revised that we receive. Nonetheless, the market has been tracking retail sales fairly closely, so it has taken on great significance. Although the seasonals are likely to depress the data, we look for a rise of 0.5% overall and 0.4% excluding autos which is in line with consensus estimates. There is some risk that pricing incentives for autos along with the negative seasonal factors will hold down the overall reading, but the underlying rebound in demand should be evident in the numbers. Since the weekly retail department store surveys have been strong, a healthy report is likely.
THE FED: STILL A RISK OF TIGHTENING–Despite the market selloff in the past week, the short end of the curve is still not priced for the possibility of another tightening move by the Fed. Two-year notes at under 6% are barely in neutral territory. Given that the Fed had a bias toward tightening in the last reported FOMC minutes, it is not surprising that there was lackluster demand at the auctions. The short end of the curve still looks expensive at these levels.
Moreover, as indicated earlier, the Fed is still relatively accommodative in terms of policy. Besides the empirical evidence of strong economy and a high real return on capital, there is the classic: money supply growth. Since the impact of changes in monetary policy works with a lag and is “long and variable” as Chairman Greenspan says, it is worth noting that money supply growth continues to advance at a healthy pace. M2 growth surged from 1995 to 1996 and has held at high levels in the past year. M3 growth is rising even more rapidly. The economy is benefiting from this money growth after that “long and variable lag” and there has been little done to reverse the trend. Moreover, credit demand is strong particularly for commercial and real estate loans. In an economy running at a fast pace near capacity constraints, the Fed is more likely to tighten to slow the pace of monetary expansion than to ease.
THE BUDGET DEAL: STILL NOT A BIG DEAL–Every few years the market seems to be enthralled with a new budget deal. This time the reasoning seemed clear: the deficit is moving towards zero. It was assumed that reducing the deficit to zero would mean reduced supply of Treasurys and therefore lower yields.
However, there is simply no empirical evidence that lower deficits mean lower yields. The two best examples on both sides of the equation are Britain and Japan. In the 1990s, Britain reduced its deficit dramatically and even began paying down debt. However, yields on gilts skyrocketed throughout much of the decade due to rising inflation expectations. On the other side of the equation is Japan. Japan is currently running a budget deficit near 6.5% of GDP but their bond yields are at record lows of 2.1%. It seems that when it comes to the debt markets, “supply creates its own demand” as Say's law indicates. It is the shift in the demand curve that has to be watched, not the supply side.
In addition, it is arguable whether this budget deal is all that great, After all, it does cut taxes in the near term and reduce spending in the long term, just as most budget deals coming out of Washington have done. It also fails to address the real issues on Social Security and Medicare. It just doesn't seem likely that there will really be a shortage of debt any time soon.
THE WEEK AHEAD: MORE SELLING IS LIKELY–Although the market has backed up dramatically in a matter of five days, the potential for follow through to the downside remains. As previously indicated, we don't look for particularly friendly economic data. At current prices, the numbers may not be all that damaging, but it is doubtful that they will reverse the market's trend. In addition, the teclinical condition of the market still looks dubious. Open interest increased sharply on the rally and as of Thursday really hadn't declined all that sharply. When Friday's figures are out, it is likely they will show a healthy drop but there still appear to be some longs that have held on and will likely be forced to liquidate,
Moreover, it is rare that after a week of sharp declines with two days of two-point declines in a week that the market reverses to the upside. Sentiment has turned and that probably means a test of lower levels still. Our intermediate-term target on the September bond contract is the 110-111 region which would take yields towards the 6.75% area. Longer term, a move back towards 7% towards year-end cannot be ruled out. We are staying with our 113 puts on September bonds but will likely take profits next week to avoid time decay now that they are in the money, We are also moving down our stop on short September bond positions from 116-12 to 114-12 to protect profits.
Kathy Jones
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