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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(October 6, 1997) FINANCIAL INSTRUMENTS: INTEREST RATES–SOMETHING FOR EVERYONE, EXCEPT FOR PROFITS–The Treasury market had a little bit of something for everybody last week, except perhaps profitable trades, Yields rose, then fell. The curve flattened and then steepened, The market rallied to new highs for the year and then fell apart. By the end of the week, bond yields were actually lower than at the start of the week but the tone of the market was weak.
There are lots of explanations for last week's price action. The economic data were mixed, providing some hope to both the bulls and the bears. Auto sales for September were weaker than anticipated at a 13.1-million- unit pace, down from the very brisk pace of July and August. In addition, the retail department store surveys were weak, suggesting that the consumer slowed down spending in September in other categories as well. These data gave the market a boost on the idea that perhaps there was a slowdown in the offing. Of course, the market has been waiting for the slowdown as long as Beckett waited for Godot, but the idea never seems to go away. In fact, the ubiquitous slowdown in consumer spending doesn't seem likely to materialize, but it rallies the market from time to time. What tends to happen in consumer spending is that it ebbs and flows in ways that make it very difficult for economists' to track. One month, it is sharply higher, the next it falls. Or consumption shifts from non-durable goods and services to household related durable goods and autos. That is why it is easier to look at the trend in consumption and the driving forces behind spending. Even with a flat retail sales figure for September, consumption appears on track to a 5% gain in the third quarter.
Moreover, why should spending or growth suddenly slow down? Job growth is still strong and income growth is picking up. Consumer sentiment is positive. in fact, consumers believing that jobs are “difficult to get” fell to an all-time low last month. The Fed has done little to slow the economy. The level of rates is attractive enough to entice businesses to borrow, banks to lend and consumers to buy houses. The normal path of the economy is expansion and without some sort of outside shock or restraint from the Fed, the expansion tends to continue. So we are inclined to believe that the slightly slower pace of spending in September was probably just a pause in an overall healthy pace.
FACTORY SECTOR STILL HUMS–Meanwhile, the manufacturing data remained strong. The NAPM Index eased down from the August high but at 54.2 remained firmly in expansionary territory. Moreover, the underlying components were generally firm. Only the inventory index fell below 50 while new orders, production and employment were all firm. Vendor delivery time eased only slightly from the recent high of 55.8 to 55.2 and most importantly the price index edged up for the third consecutive month to 54.7, the second highest reading of the year. The trend in the NAPM price index and PPI factory orders were also strong, rising 1.3% in August after a sharp upward revision to the July figure. Nondefense capital goods orders excluding aircraft still stand 11% above year-ago levels and the backlog of unfilled orders is 3% above a year ago. Anecdotally, Boeing has had to shut down three production lines because a severe shortage of parts and labor have crippled its ability to keep up with surging demand for aircraft. It is difficult to understand how the bond market could have rallied so sharply during the week in the face of these figures, but the consensus was that the small decline in the overall NAPM index was a sign of incipient weakness in manufacturing. Go figure.
BUT JOBS DISAPPEAR–The employment figures did give the market what it was hoping for on Friday. Unemployment remained at 4.9% and nonfarm payroll rose a modest 215,000 including 162,000 returning UPS strikers. The subtraction of teachers by 47,000 was a factor but even with this included, nonfarm payroll was up only modestly. Private sector payrolls were quite healthy, posting a 293,000 gain but subtracting the UPSers, the figures were still slightly below the recent trend. Moreover, the gain in hourly earnings was somewhat less than anticipated, although the August figure was revised up. Year-over-year, earnings are still in a gradual uptrend. Nonetheless, the figures were weaker than anticipated and helped reinforce the idea that the economy is starting a spontaneous slowdown.
COMMODITY PRICES–However, as Friday unfolded the market gave up the rally, finishing nearly unchanged after moving swiftly through the old highs. The ostensible reason for the decline was the rally in oil prices due to the tensions in the Middle East. Yet, Middle East tensions have been around for years and have not particularly moved the bond market. More likely it was the recognition that energy prices have been rising for several months, the result of strength in product prices and not Middle East tensions. Strong demand for gasoline and lack of refining capacity are the major reasons for the gains and crude oil has been the follower, not the leader. Similarly, agricultural prices have been stronger than expected at this time of year. Typically the late September-October time period in the U.S. is when agricultural prices make “harvest lows” and yet despite good prospects for the crop, prices have refused to fall. Finally, there has been the rally in the metals markets. Gold and silver rallied “out of the blue” earlier in the week. There seemed to be no particular reason except that the market was sold out. Actually, commodity prices have been moving erratically higher for some time, failing to decline as expected.
ASIA'S ROLE IN THE MARKET–At the end of the day, the real bullish story for the market is supposed to be the deflationary pressures in Asia and their impact on the U.S. market. To be bullish towards U.S. Treasurys at 6.30% in the long bond with a healthy economy, rising wage pressures and a Fed biased towards tightening, one would have to believe that a major force outside the U.S. is at work. That force would naturally be the deflationary pressure in Asia which could find its way to the U.S. market, either by flooding the U.S. with cheap goods and/or driving up demand for high yielding U.S. Treasurys. Such has been the reasoning in the market over the past few months since the Asian currency crisis began.
Yet, the market signals have been inconsistent with this theory. If deflation is on the border, then commodity prices should be falling and the dollar rallying. However, as indicated commodity prices were rising. Moreover, gold, the key indicator of deflation actually rallied smartly. In addition, the dollar couldn't sustain a rally either. There are two parts to the foreign investors' equation: yield and currency. The yield is good, some 425 basis points over Japanese ten-year notes. However, the dollar couldn't manage to hold much above 122 despite extraordinarily weak economic data from Japan, the major country most affected by Southeast Asia's problems. Finally, the JGB market sold off sharply and the Nikkei rallied Thursday night before the U.S. report. All of this is to say that there are enough inconsistencies to keep the market off balance for the time being.
NEW AGE VERSUS ICE AGE–Longer term, the tug of war is likely to continue. It is not just a `new age' versus `ice age' debate. Most economists, including me, will readily agree that economic growth can be sustained at higher levels in the current environment without generating significant inflation pressure than in the past. Moreover, the Phillips curve was always a rather slippery concept and very difficult to apply. However, most economists, including those at the Fed, realize that the new age theory has been helped along by some rather old-fashioned and mundane forces in the past few years. In the minutes of the August 19th FOMC meeting, Fed officials noted weak economic growth abroad, the strong dollar, flat food prices and falling energy prices as factors holding down inflation. Is the favorable secular trend in the economy reason to ignore cyclical forces? More importantly, where does the domestic economy go from here and how strong are the offshore forces?
Some helpful things to watch: the dollar and money growth. The dollar needs to remain strong in order to keep import prices down and keep the inflow of foreign capital strong. If foreign demand for U.S. Treasurys is to continue its rapid pace of earlier in the year, then the dollar shouldn't slip much below 120 yen or 1.7300 against the Deutschemark. Moreover, this equation assumes that the Asian economics stay very weak and attempt to export their way to prosperity. If Japanese officials decide to take substantive measures to boost domestic demand, then the equation will change significantly. The second factor is money supply. The Fed minutes also noted the strength in M2 in early summer. Since then, growth in the broad aggregates has accelerated. It is very difficult to make a slow growth/deflation scenario when M3 is growing at a year-over-year rate in the double-digits. The relationship between money growth and the economy is still very much intact.
THE WEEK AHEAD: MORE CONFUSION AND LESS CONFIDENCE–Next week, the market will have to start out digesting Fed Chairman Greenspan's Sunday evening comments to the American Bankers' Association meeting in Boston. He will also testify before Congress during the week and there are a host of Fed officials speaking. Late in the week, the important report will be PPI on Friday. We look for a gain of 0.3% overall due to the rising trend in energy prices and a gain of 0.3% excluding food and energy. Consensus calls for somewhat lower figures, However, in light of the recent increases in commodity prices, it may be hard to explain away lower PPI data.
A TECHNICAL NOTE–The bond market's failure on Friday suggests that it will take some very good news to get yields back below the 6.25% level again. The market has turned back from this level several times in the past few years. Moreover, there was a gap on the weekly charts dating back to the February President's Day 1996 debacle which was filled at 118-03. In a technician's view, the move on Friday was just a matter of fulfilling a long-overdue objective. However, there are still plenty of technicians looking for a re-test of the old highs in the 122 region achieved twice in the past few years. From a fundamental point of view, those highs were achieved in very unique circumstances. The first time was when the Fed still had a very accommodative monetary policy due to the problems in the banking system and the market was extraordinarily leveraged. The second time was during the slowdown in early 1996 which was exacerbated by severe snowstorms and the government shut-down. Although there seems to be a consensus that rates need to fall to those levels again and even below, it may be that unique circumstances will have to emerge to achieve that level again.
Right now, we favor continuing to view the bond market as a broad trading range affair between 6.25% on the downside and 6.75% on the upside. In the December futures, a rebound early in the week towards the 117 level looks like a good sale.
Kathy Jones
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