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INTEREST RATE WATCH
Prepared by
R.J. O'Brien & Associates, Inc.
Psychological
After a week's reflection, the market's gave a big collective yawn to Fed Chairman Greenspan's inflation warning. Although the nation's stock markets declined an approximate 2%, the recent rallies in gold, crude oil and the CRB Index failed; the Dow Jones Utility Index and the U.S. Dollar rallied; and the bond market spent most of the week higher, finishing just slightly lower.
Although bond bulls certainly had good inflation news, we're quite surprised that the credit markets held up as well as they did. In our opinion, bond futures are set up for a nasty fall. Open interest is near a record high, and the bullish speculative interest is also at a record high. According to the latest Commitment of Traders (as of 10/7/97), large speculative traders (hedge funds, etc.) have accumulated their all-time biggest net long position. Small traders, though not at a record, are also big longs. On the other side are the commercials, who are holding their largest ever net short position. Usually, when positions are at such extremes, the commercials prevail and the specs get washed out. Steve Briese, who writes the Bullish Review, and specializes in the analysis of Commitment reports, puts it this way: “Commercials have been consistently reliable indicators of market peaks in long-term interest rate futures.”
Generally speaking, large speculators tend to be trend followers, and today bond futures made a low exactly at their forty-day moving average. The bearish implication is enormous. Although there is no one certain price where the trend followers will decide that the bull trend is over, the 40-day moving average is a good enough benchmark. So as bonds move lower, not only should there be massive liquidation from a record number of longs, there may also be a large number of new shorts from these very same trend followers. Selling by the small undercapitalized traders will only add to the potential bloodbath.
Fundamental
Bond bulls can easily be forgiven for disregarding Mr. Greenspan's warning, for U.S. consumer prices remain quiet. Any alarms arising from last week's Producer Price report were erased when the Labor Department reported that prices rose just 0.2% in September. Both the overall and core inflation rates are at 2.2%, with the core rate being a new cycle low. That means the real (core) Fed Funds Rate is at a new cycle high of 3.3%.
However, given the Chairman's warning, we may be at the point where the operating theory is “what have you done for me lately?” In other words, the CPI is past history, and there was some news this week that suggested future inflation will soon rise.
Last week Federal Reserve Chairman Greenspan expressed his concern over capacity restraints in the labor force. This week's release of the Capacity Utilization report is sure to raise his worry level. The operating rate for industrial capacity use rose by 0.3% in September to 84.4%, and the previous two months' rates were revised higher by a total of 0.5%. This the highest level since April 1995, and it's a rate that has spurred an inflationary up-tick in the past.
Hand-in-hand with the capacity report was industrial production, which rose a larger than expected 0.7%. Although some bulls tried to downplay its significance by citing the large 4.4% increase in production from utilities, the strength was very broad-based. More significant, in our opinion, is the steady, strong increase we have been seeing in manufacturing output since May. The manufacturing sector is the only area where employment has not increased during the Clinton economic recovery. In fact, employment there is lower than it was ten years ago. As manufacturing continues to surge, it will put a squeeze on the dwindling supply of labor.
One of the reasons we've maintained our bearish posture has been our conviction that the Fed would respond to the higher level of U.S. economic activity by allowing short-term interest rates to rise. We have been steadfast in our opinion that the economy was stronger than most analysts and the Fed believed, and that any economic slowdown would tend to be brief. This week most reports supported our contention.
Retail sales were up a stronger than expected 0.3% (up 5.2% for the year), and the previous two months were revised higher. One reason these reports keep getting revised higher is that the seasonal adjustment process tends to distort the real picture. In this case, it's no different. Retail sales actually fell in September, as they usually do; however, they are actually 6.46% higher than last year. You can expect this months widely reported, seasonally adjusted numbers to be revised higher next month.
New claims for unemployment benefits fell again, and are 9.26% below last year. The total number receiving benefits is 10.11% below last year. Of course, as we reported last week, the actual numbers are significantly below the seasonally adjusted numbers, so expect more downward revisions to these numbers.
Housing starts skyrocketed. with the actual number 10.2% over last year. This along with the lower than expected increase in business inventories portend extremely strong fourth quarter economic growth. The bulls have been looking for a slowing economy all year long. They're apt to be disappointed once again.
October 17, 1997R.J. O'Brien & Associates, Inc.
555 West Jackson Blvd., Ste. 700, Chicago, Illinois
THE ALLENDALE ADVISORY REPORT |
STRATEGY FOCUS |
WEEKLY OUTLOOK
ECONOMIC PERSPECTIVE |
FED STEER PRICES GOING NOWHERE FAST
U.S. ECONOMIC AND INTEREST-RATE OUTLOOK
STICKING WITH THE U.S. TREASURY MARKET |
THE TODD MARKET TIMER
CASH AND BONDS-- THE RODNEY DANGERFIELDS OF FINANCIAL ASSETS?
MYERS ON FUTURES |
THE COPPER JOURNAL |
COMMODITY FUTURES FORECAST WEEKLY REPORT
INTEREST RATE WATCH |
NIKKO MARKET COMMENTS
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