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U.S. ECONOMIC AND
INTEREST-RATE OUTLOOK
Prepared by Merrill Lynch & Co.
International Fixed Income Research
After correcting briefly, Treasuries rallied after the recent NAPM report, and broke new ground after the weaker-than-expected jobs report. The latest data reinforced the notion that demand is slowing from the pace observed early in the third quarter, which was above 5%. Department-store sales, car sales, and manufacturing production all slowed in September.
With third-quarter growth likely to come in at about 3.5%, boosted by a strong 5% increase in consumer spending, we believe investors are looking beyond the current growth spurt to a general fall in real rates once growth slows to a more sustainable pace. In recent weeks, the yield curve has narrowed further in the midst of a rally (the spread between two-year bonds and 30's fell from 72 to 56 basis points in the past seven weeks); this supports the notion that inflation fears are ebbing. Also reinforcing the upward move in the market are the huge cash reserves at the short end of the curve, bullish sentiment toward the dollar, and the recognition that U.S. yields are high in relation to those of nations in much less favorable credit standing. More recently, individual investors appear to be tiptoeing back into the market, encouraged perhaps by reports of purchases of zero-coupon issues by prominent money managers.
The risk to our range has shifted from higher yields toward lower ones. Still, despite the market's performance, we think the risk of an uptick in inflation, still- healthy growth, and the Fed's retention of a bias towards tightening will limit the move to lower yields at the long end of the curve. It has become plain that the Fed will need to see actual evidence of faster inflation before it hikes rates. Although the minutes to the FOMC meetings and speeches by Fed officials suggest that a number of policymakers are concerned that tight labor markets will feed through to higher inflation, they have not found what they need to pull the trigger.
The question is when such evidence will appear. The price reports for September, the last to be released before the November 12 FOMC meeting, are not likely to look especially worrisome, at least when put into the context of the recent moderation. We now think that no Fed move is likely until at least the pre-Humphrey-Hawkins meeting in late January or early February.
Martin J. Mauro
Fixed Income Trading Strategy
In some ways, the question of the rally's sustainability will hinge on the yield curve's ability to flatten further. The “duration grab” needed to replace shortening durations of callable securities, particularly mortgages, has largely been met for now. As a result, the yield curve will likely become vulnerable to bouts of steepening as the market enters into a period of consolidation. From a longer-term perspective, we remain concerned about the market's ability to move to higher price levels, or even to sustain current levels, without a significant shift in sentiment towards the Fed. We are more concerned about the sustainability of narrow spreads across most sectors. Since some portion of the rally is a function of improving government fundamentals, we would expect the Treasury market to improve relative to the other market sectors. Partial evidence of this shift may be found in the recent widening of swap spreads. To the extent that swap spreads remain under pressure, we would expect spreads in other sectors to widen relative to the Treasury market.
Thomas J. Sowanick
(Reprinted by permission. Copyright © 1997 Merrill Lynch, Pierce, Fenner & Smith Incorporated.)
October 9, 1997Merrill Lynch & Co.
International Fixed Income Research
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