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INTEREST RATE WATCH
Prepared by
R.J. O'Brien & Associates, Inc.
Fundamental
Monetary policy appeared to be appropriately positioned–with real short-term rates relatively high to meet the Fed's objectives of resisting higher inflation pressures, while supporting a fully employed economy. (FOMC minutes [8/19/97])
FOMC noted that several factors–including the strong dollar, large U.S. grain harvests and the relatively slow performance of foreign economies–contributed to keeping inflation at bay, but possibly only temporarily. (FOMC minutes [8/19/97])
New York Federal Reserve President, William McDonough reinforced the sentiment expressed in the latest FOMC minutes when he stated today (Monday) that monetary policy is really quite tight and that real interest rates are at high levels.
It's hard for us to believe that monetary policy is tight when the growth rate of the broadest monetary measure, M3, is at its highest level since January 1987; however, we will concede that real short-term interest rates are substantially higher than the average real rate during the Clinton and Bush presidencies. (Although today's rates are low when compared to those during the Reagan years, we don't think that's a fair comparison–the nation was recovering from an inflation hangover, and rates were kept abnormally high to ward off a reoccurrence. If there is a proper measuring stick, we think it should be the Clinton years–the era of the “new paradigm,” or as some call it, the “Goldilocks” economy.)
By this measurement, today's real long-term rates are not high. Compare the current rate for the 5- and 10-year TIPS (3.54% and 3.57%) to the 5- and 10-year Treasury notes minus the current inflation rate (5.83% — 2.2% and 5.94% — 2.2%). The difference is quite slim.
But what about short-term rates? Is Mr. McDonough laying the framework for an ease? The narrowing spreads in Eurodollar futures make us think that at least some traders believe an easing in 1998 is a real possibility.
It is our opinion that any such talk is very premature. There are a number of reasons the Fed should not and probably will not think of easing any time soon.
One, the U.S. Dollar. A few weeks ago, we noted that the trade-weighted U.S. Dollar and the U.S. stock market had peaked on the same day, August 6th. Since that time, the U.S. stock market has recovered, but the dollar remains on the defensive. Why? Interestingly, last week, two events occurred which should have caused a strong dollar rally. The first event was the threat of fighting in the Middle East. In the past when this has occurred, there has been a flight to the safety of the U.S. Dollar. Last week, if there was a flight to anything, there was a flight to gold, and the dollar index actually lost ground. Secondly, on Friday the dollar gained substantially against many Asian currencies. As the Wall Street Journal puts it, Asian currencies “have entered a downward spiral to which no one can predict an end.” Yet the overall dollar index declined last week and remains on the defensive. Why? We don't profess to know the answer, but we think last week's failure of the dollar to rally is significant, and it portrays further weakness ahead. The Fed has emphasized the role the strong dollar has played in combating inflation, and it will be concerned about any future dollar weakness.
Two, new signs of inflation. Federal Reserve economists have already predicted that next year's inflation rate will be higher than the current year. Recently, there have been some signs that an upward inflation creep is starting to occur.
NAPM Index. Despite a decline in most of the NAPM indexes, the NAPM Price Index has moved higher for the third month in a row.
GDP Price Indexes. The second quarter was by marked by a slowing of consumer spending, yet prices rose. In the final Commerce accounting of the second quarter, the GDP growth rate was revised downward by 0.3%, which exactly matched the 0.3% increase in the GDP price indexes.
Capacity Utilization Rate. This is computed by the Federal Reserve itself, and it is something Chairman Greenspan watches closely. The rate is at a two-year high, and is at a threshold, which in the past has corresponded to higher inflation rates.
Three, the fix is in. In last week's Business Week, there was a timely reminder (an article entitled The Fix is In) that behind the scenes, the Labor Department has been re-computing (fixing) the CPI in order to more accurately reflect (lower) the true in flation rate. According to Business Week, the current CPI rate has been lowered by 0.2% to 0.3%, and there is more to come. When we look at the price increases we pay for private college tuition and the double digit increases in local real estate taxes, we're not real sympathetic to the argument for fixing the CPI. However, no matter which CPI rate is correct, “the fix” should remind us to be careful when comparing today's real rates with yesterday's.
Four, market action. Everybody is talking about the recent rally in gold and crude oil, so it must have caught the attention of the Fed. No doubt some of the rally is overdone, caused by overreaction to last week's events in the Middle East; yet these markets began their rally in mid-September. Also, customers should take notice that the vibrant rally in crude occurred despite the fact that oil refineries are running at 98.9% of capacity.
In addition, there may be a hint of inflation in two less discussed markets.
The grain market. The latest Fed minutes specifically mentions large U.S. grain harvests, and it is true that the U.S. farmers are at this moment harvesting an extremely large crop. Traditionally, grain prices decline as supplies swell during harvest.
Not this time. Corn and soybean prices bottomed this summer, and have moved higher. What does that imply about the ability of a large grain harvest to combat inflation?
The yield curve. The 30-year/2-year spread has recently begun to steepen. This may be just a reflection that bond yields are too low in relation to shorter maturities, or maybe even a hint that the next Fed move in '98 will be an ease. However, the curve steepens when inflation threatens, and the recent widening of the spread occurred a week after gold prices bottomed.
October 6, 1997R.J. O'Brien & Associates, Inc.
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