Prudential Securities, Inc.

The most striking characteristic of the U.S. Treasury market throughout 1997 has been its volatility. While the economy has put in a fairly steady performance, the Treasury market has been swinging from one extreme to another. Bond yields which rose to 7.20% early in the year on strong growth and a tightening move by the Fed, subsequently fell to 6.30% in mid-summer amidst perceptions of slower growth and lower inflation only to swing higher again. Recently, bond yields have fallen to new lows for the year at 6.16%. Short-term rates, although more stable than bond yields have also been relatively volatile despite the lack of action by the Fed since March.

It may be that the combination of strong growth with low inflation has kept the market off balance this year. The market's oscillations appear to reflect changing expectations about the pace of economic growth and Fed policy when in fact, both have been fairly steady since late last year. GDP growth has averaged 3.4% for the past four quarters, and the Fed has raised rates only 25 basis points in the past year. Meanwhile, inflation has edged steadily lower to 2.3%. However, the quarter-to-quarter ups and downs of the economy have led to periodic ups and downs in expectations and interest rates.

The subtext to these expectations and the subsequent ups and downs in the economy as well as the major issue facing the market is whether the recent trends can be sustained. Can the economy continue to grow at a strong pace without generating inflation? With yields near the lows for the year after extremely strong first half growth, the market appears to be assuming that it is possible. The assumption is that the economy is in a “new era” in which strong growth can co-exist with low inflation indefinitely. Yet there is little data to support this view.

Although we hold the view that the threshold of non- inflationary growth has probably moved higher in the past decade, it should not be used to justify overvaluation in the financial markets. As a result, our major concern is that the market is far too optimistic about the interest rate outlook going forward.

The U.S. economy has put in a very strong performance all year. Despite worries about a second quarter slowdown, the pace of growth has remained above 3% and has recently accelerated. Year-to-date, growth has averaged 4.2%, the best performance since the expansion began in 1992. Moreover, growth has been broad-based with rising trends in consumer spending, manufacturing, business investment, housing and exports.

The leading indicators of economic growth point to further gains ahead as well. The manufacturing sector remains robust. The NAPM index has been above the 50% line since the first quarter and has accelerated to the upside in recent months. The index is correlated with a rising trend in industrial production. Moreover, the factory orders data indicate that the backlog of unfilled orders has been rising for two years and is approaching the highest level of the decade, suggesting that the next six to twelve months will witness rising output as businesses struggle to keep up with demand. The manufacturing sector reflects a diminishing portion of the economy but continues to be a leading indicator for the overall economy. As a result, the strength in this sector portends stronger growth ahead.

Housing is another leading indicator of activity where the trend remains strong. Although housing starts have edged down a bit in the past few months, demand for housing and housing-related goods is rising rather sharply. The National Association of Home Builders' index rose to 59 in September, the highest level in over a year. Existing home sales hit a record high level in August. Mortgage applications have surged and home prices have risen about 5% on average this year, all of which suggests strong demand for housing. Moreover, the inventory of unsold homes is near the lowest level for the business cycle which points to the likelihood of increased housing and construction activity going forward. Finally, demand for household-related durable goods such as building materials has been rising quite sharply in the past year.

The key driving force behind the economy's strength is consumer spending. Typically, business cycles are sustained by consumer spending, which accounts for about two- thirds of GDP. In turn, spending is propelled by growth in employment and disposable income. Not surprisingly, the market has been focusing very closely on consumption. The trend in short-term rates has been following the trend in retail sales in a nearly lockstep fashion for the past few years.

The outlook going forward remains healthy, though not without the usual ebb and flow. Income growth has been accelerating during the past year. In fact, at the current pace of growth in disposable income, spending should be sustained at about a 3.5% pace well into 1998. Moreover, employment growth has risen at the fastest rate in over a decade, pointing to further gains in spending as well. Consumer confidence remains strong and debt levels appear more manageable now than they were earlier in the business cycle. Consumers have whittled down the debt/income ratio by using less credit. The expansion in consumer credit demand is now running at about half the pace of a year ago.

On balance, consumers appear to be in good shape to keep spending growing at a healthy pace through year-end and into early next year. In fact, the holiday season should be a good one for retailers. One of the better forecasting tools for the holiday season is to look at the year-over-year pace of spending for the “back to school” season. Typically, the pace of spending in the late August/early September time period is correlated with the pace of spending during the holiday season. Since back-to- school sales jumped a sharp 7% over last year, the outlook for consumer spending into year-end remains strong. Moreover, the number of consumers indicating that jobs are “difficult to get” fell to a record low in September, according to the Conference Board.

In addition, the recent sharp rise in the pace of money supply growth suggests further gains in spending and GDP growth as well. There is a correlation between broad money supply growth and GDP growth. On a theoretical basis, it is clear that deposits held by consumers are correlated with spending. The only question is how long the lag between the rise in liquidity and a subsequent rise in spending will be. Money supply growth, which tumbled in the 1993-94 time period has surged since late 1995. It is now growing at the fastest rate in over a decade. Given the two- year lag between the time money growth began to pick up and the recent surge in spending, it is apparent that there is plenty of liquidity to drive the economy at a fast rate in the next six to twelve months.

Yet, even with all of the signs of strong growth, interest rates have remained fairly low because inflation has remained low. It is this link between growth and inflation that is now in question. Economic growth by itself doesn't cause inflation. Inflation is the result of growth in excess of the economy's capacity to produce. In other words, there is “too much money chasing too few goods.”

The argument that favors the high growth/low inflation scenario suggests that as long as capacity is expanding at a rapid pace, then strong growth can be sustained without inflation. Those who favor this argument cite the huge expansion in business investment in the 1990's, particularly in technology, as reason to believe that capacity is expanding faster than growth. However, looking at the difference between the pace of broad money growth and the pace of capacity expansion, it appears that there is a lot more money being created than capacity. Broad money growth has exceeded capacity growth by more than 5% over the past two years. In the past, monetary expansion of this pace in excess of capacity expansion has resulted in higher inflation with a one- to two-year lag. As such, a pick up in inflation would be seen in 1998 if this relationship continues to hold.

With capacity utilization now approaching the 84% level, the case for excess capacity seems to be waning, except inasmuch as lower cost imports can be substituted for domestic goods, thus alleviating some of the pressure on the manufacturing sector. The data do indicate a rising trend in imports, but despite the increase, imports as a percent of GDP are only up to 2%, which is not a high enough level to signal that capacity has expanded globally enough to substitute for tightness in the U.S. product markets. In fact, it is apparent that prices for goods at the crude and intermediate processing level have been moving up for more than a year. They are only beginning to post year-over-year increases, but the trend is towards higher, rather than lower prices for the first time in years.

The underpinnings of the inflation story are probably more mundane than the “new economy” theory proposes. Our current low inflation is the result of four factors:

1. The delayed impact of slow money growth in early 1990's;

2. the squeeze on labor costs for much of the business cycle;

3. weak global growth, and;

4. a strong dollar.

Money Growth

Money growth was quite weak throughout most of the early 1990' even as the expansion began to take hold. The Federal Reserve's decision in 1994 to double the Fed funds rate, tightening policy sharply, resulted in a steep slowdown in money growth and put the brakes on growth and output until 1996. Since then however, policy has gradually become more neutral to accommodative. Nominal domestic demand is now growing at a faster rate than the 5.5% Fed funds rate, at a time when unemployment is quite low and capacity utilization rates are near cyclical highs.

Labor Costs

On the labor cost front, much of the good news appears to be waning as well. Throughout much of the late 1980's and early 1990's, labor costs were declining. For the past year, wages have been edging higher, the result of a drop in the unemployment rate below 5%. To date, employers have been able to hold down overall labor costs by reducing the cost of benefits to offset rising wages. However, at some point, it is going to be more difficult to cut benefits as the labor market tightens. In fact, the recent UPS strike and other union actions suggest that the squeeze on labor costs may have just about run its course for this cycle. The labor force, which has expanded to record levels during this cycle, is not likely to continue to grow at such a rapid rate going forward simply because most of those who want to be employed have probably already found work.

Weak Growth And Excess Capacity Globally

The U.S. inflation outlook has also benefited from weakness in growth in the other G7 countries throughout the 1990's. The impact of German unification and European Monetary Union on Europe's economies was severe, causing recessions in those countries and a huge increase in unemployment and excess capacity. As a result, even as the U.S. economy expanded, there was ample excess capacity globally to keep prices low. Similarly, Japan's sharp downturn in the 1990's due to the bursting of the “bubble economy” has helped hold down price pressures.

However, the non-U.S. G-7 economies, after years of very low interest rates and currency depreciation, are beginning to see stronger economic growth. Here too, the rising liquidity in these countries over the past few years, is finding its way into real economic growth. Canada and the U.K. are already well into the expansive stage of the business cycle and have already tightened their monetary policies. Now continental Europe is beginning to pick up and even Japan will likely witness better growth next year. In fact, 1998 will likely be the first year in this decade when all of the G7 countries will grow at a 2.5% GDP growth rate or higher.

The Rising Value Of The Dollar

More than any other single factor, however, it is the rise in the dollar from the 1995 lows that has helped to hold down inflation. The steady uptrend in the dollar over the past few years has held down import prices, substantially contributing to the good inflation performance. It is estimated that a 10% rise in the dollar can shave about 1% off of consumer price inflation; yet, since mid- summer, the dollar has faltered. Even if the dollar stabilizes, we are not out of the inflationary woods. All that has to happen is that the dollar remains stable and the incremental impact on import prices will be lost.

One of the frequently heard arguments for substantially lower interest rates is the analogy of the current U.S. economy with the U.S. in the 1960's. The argument posits that in the 1960's, the U.S. economy grew at a strong rate with low inflation and that interest rates were substantially lower than they are now. Therefore, now that the strong growth/low inflation era has returned, why haven't nominal and real interest rates declined?

Although the analogy is compelling, there are some significant differences between the 1960's and the current era. The U.S. is now a net debtor nation whereas in the 1960's the U.S. was a net creditor to the world. The current account deficit is running at about $40 billion per quarter, or $150 billion per year, which is only about 2% of GDP and a manageable level. However, as a net debtor, the U.S. must import foreign capital to the level of the current account deficit. So far, in the past few years, importing foreign capital has been relatively easy because nominal U.S. interest rates have been much higher than those abroad and the dollar has been rising.

In fact, the U.S. has imported far more than the $150 billion in capital needed to fund the deficit. The actual amount of capital flowing in over the past year has exceeded twice that amount. Much of that capital found its way into U.S. Treasuries which allowed interest rates to fall even as domestic investors were net sellers of Treasuries.

The question is, how sustainable are these “uphill capital flows” in a lower interest rate environment? It all depends on the dollar. As economic growth and interest rates pick up abroad and the U.S. Dollar edges lower, the inflow of foreign capital is likely to slow. In fact, foreign buying of U.S. Treasuries has slowed in the past quarter from the very rapid rate seen earlier in the year. Foreign purchases of U.S. Treasuries totaled $72 billion in the first quarter but fell back to $36 billion in the second quarter. Moreover, the dollar has fallen about 5% on a trade-weighted basis from its highs. A weaker dollar will most likely shift the demand curve for U.S. Treasuries. As a result, in order to “clear the market,” interest rates will need to rise, either to satisfy foreign investors for the currency risk or to attract domestic investors out of other investments.

In the 1960's, the U.S. did not need to compete for foreign capital in the world's markets. The dollar traded at a fixed exchange rate, the banking system was highly regulated and the U.S. was a net exporter of capital.

As we indicated earlier, Fed policy is neutral to accommodative. Although the spread between the current Fed funds rate and inflation is relatively high at 3.20%, it is only modestly above the long-term average. Moreover, nominal domestic demand is trending higher than the Fed funds rate and money and credit growth are expanding rapidly. These are signals that policy, far from being restrictive, is actually fairly loose.

In addition, looking at previous cycles, it appears that the level of the Fed funds rate itself has less of an impact on the economy than the change in the cost of funds. That is, the economy appears to adjust fairly quickly to the level of interest rates, but responds more strongly to the rate of change in interest rates. Given that the Fed has raised interest rates only one time in this cycle and only by 25 basis points, there has been little impact on the economy. In a seven-trillion-dollar economy, a modest rate hike is not going to have much impact. If the Fed does decide that the pace of growth needs to slow, then it will take more aggressive action in the next few months.

Based on our outlook for strong economic growth, gradually rising price pressures and a slowdown in the pace of foreign investment, we look for interest rates to gradually work higher into early 1998. Current interest rate levels are not particularly high given the level of growth. The real yield on the ten-year note tends to move in sync with the level of real GDP growth. Currently, ten-year notes yield about 3.6% after inflation, matching the year-over-year rate of growth in real GDP.

The Fed will probably raise the funds rate to 6% over the course of the next two quarters, sending bond yields back towards the 6.75% to 7.0% region by March 1998. We favor selling December 97 and March 98 T-bonds on rallies towards the 117-118 level in anticipation of a decline to the 108-00 to 110-00 level longer term. We also favor buying March 1998 116 puts at under 50 ticks.

In the short end of the yield curve, the market is not priced for higher interest rates. Hence, if our forecast for tighter Fed policy and higher rates is correct, then the biggest yield change would be seen in the two-year and under duration sector of the curve. In this sector, we favor selling March and June 98 Eurodollars at current levels.

October, 1997Prudential Securities, Inc.

One New York Plaza, New York, New York

Consensus National Futures and Financial On Line Index

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