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PRUDENTIAL SECURITIES, INC.
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(September 29, 1997) FINANCIAL INSTRUMENTS: INTEREST RATES–VOLATILITY HIGH/CONFIDENCE LOW–About tile only thing that seems certain in the Treasury market is that volatility is likely to remain high as the bulls and bears fight out the direction of the market. Last week witnessed some wide swings in the market, but bonds ended nearly unchanged on the week suggesting that neither side had enough confidence to push the market out of its range.
Part of the explanation for the market's inability to either follow through on the recent upmove or decline substantially can be explained by lack of significant data. Last week's calendar was light with only durable goods orders, Q2 GDP revisions and the usual weekly reports to move the market. On balance, the economic data continues to point to a healthy economy. Durable goods orders rose by 2.7% in the latest month, paced by gains in aircraft and electronic equipment. Although stripping away aircraft and defense revealed some weakness in orders for the month, the trend has been so strong all year that a one-month slowing is not likely to be seen as a change in trend. The figures imply that third-quarter investment figures will be somewhat below the blistering 22% pace of the second quarter, but that rate was probably unsustainable anyway. Nonetheless, industrial output looks likely to once again post a growth rate of nearly 5% in the third quarter, keeping overall GDP growth in the 3% range or above.
Housing also continues to contribute to growth in the economy. Existing home sales hit a new high for the 1990's during August. With mortgage rates down, consumer confidence, job growth and income on the rise, it would be difficult to make the case for anything other than strength in the housing sector going forward. Moreover, housing prices are rising at a 5% pace on an annualized basis, something which should spur optimism further going forward. In fact, the Mortgage Bankers' Association Index surged to a new high last week signaling more housing activity going forward.
On the demand side, the signals point to a slightly slower pace of consumer spending in September than in July-August, but not a substantial decline. The weekly retail department store surveys have indicated some softness but with the jump in spending seen in the past two months, a slight softening in the pace is most likely just a pause. In fact, spending could be flat in September and third-quarter consumption would still grow at a healthy 4% clip in the quarter. It would not be surprising to see a stronger figure.
Another development worth watching is the decline in the dollar over the past ten weeks. The dollar's strength has been a major contributing factor in holding down inflation over the past few years. Import prices have declined during that time and are actually negative on a year-over-year basis. It is not a coincidence that the high in the bond market August 1st coincided with a high in the dollar. From here on out, if the dollar does not appreciate further, the inflation outlook will worsen. The dollar doesn't have to decline. It simply has to stop rising and then the year-over-year change in import prices will likely shift from negative to positive. We aren't looking for a major drop in the dollar from current levels but it has already fallen 7% against the Deutschemark and 5% on a trade-weighted basis.
With inflation so low however, the market remains priced for no major shift in the outlook. The expectation remains that the economy can grow at a strong pace because capacity is expanding in line with demand and therefore, the balance between the two will continue to produce stability. However, the risks are rising, whether they are priced into the market or not. On the demand side, the tightening in the labor markets and rising trend in wages suggests that spending could outstrip supply in the next one to two quarters. Continuing claims for unemployment fell to the lowest level since 1989 during the past reporting week, suggesting that employers will continue to bid up wages for higher skilled labor. In fact, there is just such a trend in place. To date, the rise in wages has largely been offset by a decline in benefits, but how much longer can that continue with a scarcity of labor?
The output gap is believed to have closed in late 1996. The output gap is the Fed's estimate of the difference between the economy's capacity to produce and its actual rate of growth. After a long stretch of historically sub-par growth in the early 1990's, the output gap has been closed. Even with the rapid pace of investment in the past few years, demand appears to be poised to outstrip demand. Industrial capacity is rising at about a 3.7% pace. Spending growth is rising at a 5% pace. Moreover, money supply growth is expanding at an 8% pace. For a monetarist, the recent surge in money growth points to “too much money chasing too few goods.” There is usually a five- quarter lag between closing the output gap and a rise in inflation pressures. If our estimate of when the gap closed is correct, then inflationary pressures are likely to show up late this year or early 1998.
Meanwhile, the market is not priced for a change in the outlook. The Eurodollar curve is basically flat with no rate hike priced in for six months. In fact, the entire yield curve is flat suggesting a very optimistic long-term view. The implied inflation expectations in TIIPs is just 2.5% even though the real rate of growth is running at 3.5%. How realistic are these expectations seven years into the expansion? They will hold only if the “new era” has arrived.
In the week ahead, there will be plenty of data to test both the bulls and the bears. Early in the week the personal income figures should confirm that consumers have the capacity to continue spending at a healthy pace. Then the Chicago Purchasing Managers' report will be released. The index jumped sharply to 64.3% last month, so some decline is likely. However, if the index holds in the vicinity of 60%, it will point to a very healthy manufacturing sector as should the NAPM report. Later in the week, there will be auto sales data which should point to ongoing strength in consumption, Finally, the ubiquitous Unemployment report will be released on Friday. Expectations are for the rate to remain at 4.9% with nonfarm payrolls up 330,000. As usual, there will be some quirks in the figures. The Bureau of Labor Statistics has already indicated that the 185,000 UPS workers will be taken back into the figures after being on strike last month. However, this increase will likely be offset by a drop in “local government hiring” which means teachers returning to the workforce. Last month's increase is likely to be this month's decline due to seasonal adjustment problems. We look for a drop of about 40,000 to 50,000 in this category. If one assumes that all of the strong signals from the labor market point to a trend figures for nonfarm payroll of about 225,000 then add in 185.000 UPS workers and subtract 50,000 teachers, the net is about 360,000. It looks like the consensus estimate is just shy of that figure, but the risk is probably to the upside on this number.
Of course there is a meeting of the Federal Reserve next week, but that has not captured the market's attention. No one expects a rate hike at this meeting since inflation has been so well behaved, so there is no risk premium built into the market for a surprise event. Nonetheless, the meeting will probably keep the market cautious early in the week.
Our intermediate-term view continues to be that the market is more likely than not to back off from the recent highs. Real bond yields and real growth tend to move in tandem for good reason. The return on capital climbs as the economy expands and that means that capital is bid up. Hence, the 3.5% to 3.7% real rate on the ten-year note is consistent with a real GDP growth rate of 3.6% over the past year. Real rates, in this context, are not particularly high by historical standards. Moreover, the economy is not known to slowdown spontaneously. It usually takes some help from the Fed.
Hence, we see the risk to the upside in yields over the next few months. The short end of the yield curve appears particularly vulnerable to a surprise. We continue to favor the short side of March 98 and deferred Eurodollars. Bonds look to be a good sale near the old highs in the 116-20/30 region. Out-of-the- money puts look to be a good way to hedge as well.
Kathy Jones
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