wmeubank@ocp.kcmo.com
PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(October 13, 1997) FINANCIAL INSTRUMENTS: INTEREST RATES–OOPS: THE MARKET GOT IT WRONG–The Treasury market looks like it has topped. Although there are still hopes for another test of the highs, the likelihood is diminishing. Fed Chairman Greenspan went out of his way to signal to the market that the Fed is still ready to raise rates, that he is not a “new era” guy and that the markets were overvalued. To top it off, PPI posted its single largest gain in a year. Bond yields, in one of the more volatile trading weeks in memory, rose more than twenty basis points week-to-week and added nearly thirty from the low of the move last Friday.
GREENSPAN IS NOT A NEW ERA GUY–The surprise of the week was Fed Chairman Greenspan's testimony before the House Budget committee. The testimony, which wasn't expected to contain any new material, turned out to be quite a surprise. Greenspan went out of his way to let the market know that he does not believe that there is a “new paradigm” working in the economy and that he sees the risk in inflation to the upside. Apparently Greenspan was bothered by the market's reaction to his July Humphrey-Hawkins testimony which he believed was “misinterpreted.” He couldn't have been clearer.
He debunked the idea that the economy has entered a new era. Despite his belief that productivity is understated, he still believes that the business cycle exists and cannot be repealed. He dwelled heavily on the tightness in the labor markets and the inevitability that it will lead to a transmission of rising wages to upward pressure on prices. Although the product markets remain in better balance than the labor market, he also noted that there is little excess capacity and the factors which had limited pricing pressures may be abating. He reminded the market that it was only three years ago that capacity constraints were reached and that we are now approaching those levels again. As for the reasons inflation has been so low, he noted “temporary factors” such as the rising value of the dollar holding down import prices, slow growth abroad and the good fortune that energy prices declined earlier in the year.
There isn't much to add to the argument. It has been clear for some time that the tightness in the labor markets was already sending wages higher. Jobless claims have fallen to the lowest level of the 1990's and wages are steadily rising. So far, overall labor costs have been held in check by the ability of firms to cut benefit costs, but that is not an endless trend. In fact, the recent fallout in the HMO market is a reflection of the pressure on providers to boost care. Eventually a higher level of care will prove more costly and that cost will have to be passed along. Similarly, the good news on inflation stemming from a rising dollar is probably over. The dollar peaked in early August and has eroded modestly since then. The magnitude of the decline is less important than the fact that it is no longer rising and therefore, no longer holding down import prices. As important is whether the weaker dollar will slow the inflow of foreign capital. The trend in Fed custodial holdings of Treasurys has flattened out after many years of steep advances. In fact, they have been declining since August.
Perhaps the most important message in the testimony was the one most overlooked by the market. Greenspan threw cold water on the notion that the budget was moving into balance or surplus. He very bluntly pointed out that the budget rests on very optimistic economic assumptions and does not call for spending cuts until the last two years at which time, there will probably be many new faces in Congress and little political will to make those difficult decisions. Moreover, he noted that when Social Security and Medicare are taken into consideration, the budget is still very much in deficit and will remain that way. With everybody in Washington running around trying to figure out how to “spend the surplus,” it is refreshing to hear a realistic appraisal of the budget. How many basis points have been taken off the bond market on the notion that the budget will be in surplus soon?
COMMODITY PRICES, PPI AND MONEY SUPPLY–The inflation outlook took something of a turn for the worse last week as well. The PPI report indicated a jump of 0.5% overall and 0.4% excluding food and energy. The figures were above consensus expectations. Although there are various ways to explain away the numbers (take out energy, autos, tobacco and food and you get a good number), the fact is that it was a bad number for the market. The gains were broad-based and although some will be reversed, many will likely remain trending higher. Energy prices have continued to rise in the weeks since the last report and will likely mean another increase next month. Food prices have skyrocketed at the wholesale level despite the outlook for ample harvests in the U.S. Foreign demand appears particularly strong right now and with the complicating factor of El Nino potentially reducing crop size globally, food prices look likely to remain high on a year-over-year basis. Auto prices will probably pull back as there have been new incentives announced, but tobacco prices are likely to post another increase next month as the full impact of the recent price hike was not transmitted in this report.
Longer term, the signals on wholesale prices are pointing higher rather than lower. The NAPM price index has been steady advancing for several months. The PPI core and intermediate goods indices have climbed from sharply negative territory to slight increases. The cyclical advance is very similar to the pattern seen in 1992-93. The CRB Index has risen sharply lately and even the gold market has rebounded from its lows. Although the market seems to be counting on “global competition” to hold down prices, the quickening pace of economic activity abroad would seem to diminish the likelihood. European central banks raised interest rates last week, signaling a shift in the rate cycle there. There have already been higher rates in the U.K. and Canada, so the only region left is the Pacific Rim.
As for inflation, it is still a monetary phenomenon and the accelerating trend in money supply growth suggests that more, rather than less, inflation is likely ahead. Last week's money growth took both M2 and M3 higher again. M2 is rising at a 5.6% pace over the fourth quarter base, while M3 is up 8.4% over the fourth-quarter base. On a year-over-year basis, the increase has accelerated to a 12.7% pace. Moreover, bank lending has risen sharply as well. Commercial and industrial loans posted a 11.5% increase in September while real estate loans rose 7.8%. The consumer sector is the only area where loan growth is slowing, but the rise in refinancings suggests increased consumption going forward.
THE WEEK AHEAD–The bond market is likely to get a bit of respite from bad news next week. There are several economic reports but the focus will probably be on retail sales and CPI. Given that auto sales declined and chain store sales were weak, it looks like September retail sales probably fell 0.1% over-all while rising 0.2% excluding autos. The downturn in spending in September is probably just another of the many pauses in consumption seen in the past two years. but it is likely to be supportive to the market as it alleviates concerns about overheating demand in the near term. For the fourth quarter as a whole however, we still look for healthy consumption as the holiday season still looks likely to witness strong spending.
CPI is expected to rise 0.3% overall and 0.3% for the core rate. The rise in energy and food prices should bolster the overall index, while an array of factors are expected to push up the core rate. Apparel prices are expected to rebound from last month's decline. Transportation prices and housing also look likely to increase. Medical costs have continued to be tame, but the risk appears to be on the upside. Air fares and tobacco prices will probably also contribute to higher figures. Nonetheless, even with these increases, core CPI would only be running at 2.3% which would provide some comfort to the market near term.
Gains are likely to be limited however, but the warnings from Greenspan and expected gains in the Philadelphia Fed Index, housing starts, industrial production and capacity utilization. In addition, Greenspan is scheduled to speak at the Cato Institute October 14th on “Money and Capital Flows.”
MARKET OUTLOOK–We look for some recovery in the market next week. However, the upside potential should be limited by the prospect for Fed tightening, rising interest rates abroad and a still strong economy. It seems unlikely that rates can fall to new cyclical lows when the economy is near a cyclical peak in growth and the central bank is poised to raise rates. That leaves us still advocating short positions in December bonds. We are holding an existing position at 117-07 with stops moved down to protect profits at 115- 27. However, there is probably a better trade to be made in Eurodollars which, despite the sharp fall last week, have yet to price in much tightening. Hence, we favor selling March 98 and deferred Eurodollars at current levels. The short end of the curve still appears rich. Two-year notes are likely to trade back towards the 6% level if we are right that bond yields are headed back towards the 6.75% region.
Kathy Jones
Added to the WWW 10-17-97
Last updated on 10-17-97
Hosted by:
One Crossroads Place
610 West Maple Ave, Suite WWW
Independence, MO 64050
(816) 252-4080
sysop@kcmo.com