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Commentary
“To succeed in life, you need two things: ignorance and confidence.”
- Mark Twain
A Slowing Economy: False Alarm?
On the heels of a 4.7% unemployment rate, growth in non-farm payroll of 211,000 workers, and a 3.4% increase in average hourly earnings during the month of March, the year-to-date employment picture looks brighter than at any time in over six years.
With the strong employment situation report, few doubt that the Fed will tighten yet another 25 basis points at it’s meeting on May 10. In advance of the May meeting, the Fed will also have the April employment report. Another strong report would increase the likelihood of tightening to 5.25% from “possible” to “probable” at the June 29 meeting. The term Fed funds market now assesses a 45% probability of an increase to 5.25% at the June meeting.
Stronger Confidence, Keeping a Close Watch on the Inflation Gauge
Other signs that economic activity remains robust:
- Things continue to look fine on the corporate front. S&P 500 member earnings have increased by more than 10% for each of the last 14 consecutive quarters. According to the Commerce Department, corporate profits in the fourth quarter constituted a record 11.6% of GDP. Also, the National Association of Purchasing Management index rose to 60.4 for March, a healthy increase from February’s reading of 54.9.
- Consumers also appear more sanguine, as evidenced by the University of Michigan index of consumer sentiment rising to 88.9 for April, a healthy increase from 86.7 for March. Reasons cited: low unemployment levels and rising wages.
- Current initial estimates call for an increase in first-quarter GDP (April 28 release date) on the order of a frothy 4.5%—a strong rebound from the 1.7% growth rate recorded during the fourth quarter.
Traditional inflationary barometers are starting to register. Gold is now trading above $600 an ounce. Crude oil prices, now above $68 per barrel, appear poised to match last year’s high of $70.85. As a counter to the inflationary bandwagon:
- The difference between 10-year Treasuries and 10-Year Treasury Inflation Protected Securities (TIPS) has narrowed slightly over the past month. That yield difference, now at 2.50%, represents the market’s view of the average rate of inflation over the next 10 years.
- The Fed’s preferred measure of inflation, the personal consumption expenditures (PCE) rate of inflation, rose by only .1% during February. Also in February, the Fed stated its belief that the PCE inflation index would rise between 1.75% and 2.50% during 2006.
Anecdotally, at least, the Fed does not appear overly concerned about inflationary pressures. In the past week, five Federal Reserve presidents spoke of healthy economic growth without a mention of unacceptable levels of inflation. William Poole, president of the St. Louis Federal Reserve and perceived as one of the FOMC’s more hawkish members, stated, “As long as the inflation rate stays where it is, there’s no reason not to have the economy continue to grow… There are pockets of tightness in both the physical capacity and the labor market, but there are a lot of other places where there’s a lot of excess capacity.”
Inversion: Out of the Woods?
The yield curve, as represented by the spread between two-year and 10-year Treasuries, is now a positive seven basis points. Throughout February, the yield curve was consistently inverted, with negative spreads between the two securities peaking at 16 basis points on February 16. Ten-year yields are now approaching 5.00%. That’s a significant move from this year’s lowest yield of 4.29%, which occurred on January 18.
If the yield curve continues to steepen, the source of that steepening (whether it’s a relative reduction in short-term rates or a relative increase in long-term rates) will be a closely watched variable. How might relative short yields drop? If markets assume that the Fed will stop raising rates anytime soon. (Should we call it an end of tightening or an end of the march toward neutrality? Probably the latter!) Let’s hope it doesn’t emanate from a credit or housing bust.
The real fun would start with a yield curve that steepens due to a relative increase in long-term rates. What might trigger a disproportionate increase at the long-end?
- A reallocation of foreign exchange reserves by China, translated as a reduction of its dollar-denominated holdings. China now holds in excess of $250 billion of U.S. Treasuries. Then again, would China bite the hands of the U.S. consumers that feed it?
- A shift in the focus of the foreign exchange markets, away from yield differentials to current account deficits. This would drive yields in the U.S. upwards, disproportionately at the longer-end.
- Increasing expectations of inflation. Here, we need to watch two key indicators that are presently ambivalent on the subject: the PCE inflation index and the spread between Treasuries and TIPS.
Shrinking Volatility and Stronger Mortgage-Backed Securities Performance
As we mention in this month’s issue of What Counts, rate volatility has been approaching six-year lows. Sounds familiar? Strong employment and a flat yield curve à la 2000? Falling volatility has helped the relative performance of mortgage-backed securities due to less variance in prepayment expectations. During the first quarter’s condition of rising rates, the Merrill Lynch Index of mortgage-backed securities supported a total rate of return of -3 basis points; better than the -104 basis points attained by the longer-duration Merrill Lynch Index of U.S. Government Debt.
John Biestman is Director of Business Development at the Federal Home Loan Bank of Seattle.
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