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Commentary
“The science hangs like a gathering fog in a valley, a fog which begins nowhere and goes nowhere, an incidental, unmeaning inconvenience to passers-by.”
- H. G. Wells
Slow Growth: At Least According to the Yield Curve’s Historical Precedent
Even though we are approaching the dog days of summer, the markets remind us of one of those endless, fog-bound, inversion-induced periods one might find in the Treasure Valley of Idaho or the Salt Lake Basin in the dead of winter. It’s a condition in which our patience wears thin as we await even the slightest breeze to restore our sense of direction.
For the first time since 2000, the targeted Fed funds rate exceeds the yield on 10-year Treasuries. This has occurred six times since 1971. On five of the six occasions, at least two consecutive quarters of negative GDP growth followed shortly thereafter.
Immediately prior to the June employment situation report, the spread between two-year and 10-year Treasuries was flat. As of this writing, the spread has inverted to six basis points.
Futures markets are presently assessing a 60% probability that the Fed will raise its target to 5.50% at the August meeting. Prior to the release of the minutes of the FOMC’s June 29 meeting (at which the Fed acknowledged that evidence of a slowing economy could prompt a halt to additional rate increases), the odds had been 85%. According to the Fed, additional rate increases above the current target level of 5.25% would be dependent upon “the outlook for both inflation and growth.”
Our monthly survey of select economists shows an expectation of third quarter growth of 3.1%, a slowdown from the 5.6% GDP growth rate that occurred during the first quarter. The survey also shows that the Fed funds rate is projected to exceed 10-year Treasury yields throughout next year.
Out of the Inflationary Woods?
Last week, Bill Gross, chief investment officer of Pacific Investment Management Co., proclaimed that the bear market in bonds may have reached its logical conclusion. However, the hard reality is that, year-to-date, the fixed-income market has shown signs that we may not be out of the woods just yet. Indeed, it’s hard to think that U.S. bond markets have registered the poorest total rate of return since 1999, with the Merrill Lynch Treasury Index having declined by 1.08% this year.
Treasury Inflation Protected Securities (TIPS) spreads have widened versus 10-year Treasuries, by roughly five basis points in the past month. That squares with the parting shots of the June FOMC meeting which specified that “high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures.”
It’s clear that the markets are not yet convinced that the embers of “cost-push” inflation have been extinguished. On that score, crude oil reached a price of $75.78 on July 7. That’s a month-over-month increase of 6.3%. We should not forget that for the first five months of this year, the Consumer Price Index (CPI) has been running at an annualized rate of increase of 5.2%. That’s up from the 3.6% rate of inflation that occurred during the similar period in 2005.
Still, the Fed rhetoric emanating from the June meeting took a convincing turn. As opposed to previous hawkish talk on inflation, this time around, the Fed stated its belief that evidence of a slowing economy “should help to limit inflation pressures over time,” notwithstanding the cost-push pressures in the food and energy sectors. The key factors that are containing the inflationary menace: improved global supply-chain management and simply the fact that companies and consumers are becoming more efficient in their use of raw materials.
Bottom line: The Fed appreciates the lagging effect of monetary policy and the historical risk of overcompensating; thereby decelerating the economy too quickly. Along these lines, the Fed has acknowledged that it is currently in a period in which their actions are “data dependent.” The Fed will rest on its oars once further tangible signs of a moderation in inflation and economic activity come to pass. Watch for further details on July 19 when Chairman Bernanke appears before the Senate Banking Committee for his semi-annual report on prospects for inflation and economic growth. Coincidentally, that’s the same day that the CPI is scheduled for release.
Who’s Got the Right Call on Job Growth: ADP or BLS?
For a brief moment, the markets were treated to a bullish payroll report when payroll processor Automatic Data Processing, Inc. reported that its companies added 368,000 jobs in June—the largest monthly increase it had seen since it began keeping records in 2001. The report also showed that the rate of participation in the labor force had increased to 66.2%, the highest level in nine months.
Call it a seasonal fluke, or the fact that more and more teenagers may be getting on the summer job bandwagon (not likely because teenage unemployment has been on the rise), but the Bureau of Labor Statistics reined the markets back in from its “off-sides” position with a weak 121,000 increase in payrolls. Why the dampened job growth? Construction employment dropped slightly, and the financial services and retailing sectors reported weak payroll growth.
The report also showed that hourly earnings, on an annualized basis, increased by 3.9%. That’s the largest monthly wage gain we’ve seen in almost five years. Altogether, the data dependent market saw two signs emanating from the report: (1) good evidence that the labor market may be slowing down, and (2) signs of building wage pressures. Clearly the Fed will be focusing on the earnings component of forthcoming employment reports for signs of waning productivity and/or wage inflation. Still, there may be some noise in the hourly earnings numbers, as a portion of recent increases may simply reflect an offset to diminished defined benefit and heath care contributions on the parts of many employers.
Better News on the Trade Deficit Front
In spite of rising oil prices, thanks to a year-over-year decline in the dollar of approximately 5%, and to a growing amount of demand for exports to Europe and Japan, the May trade deficit figure came in at $63.8 billion. Imports grew by 1.8%, while exports grew by 2.4%. The export sector, still operating at a base that is substantially smaller than imports, will need to show further improvement in order to compensate for a widely anticipated reduction in the growth rate in consumer spending.
Return to Sender: An Action Step In an Uncertain Rate Environment
If weaker economic data follow and the Fed eases up on the reins, the lessons of the 2003 should remain fresh. During that time, institutions holding fixed-rate assets without prepayment penalties (e.g., fixed-rate mortgages) prepaid at speeds that were far greater than anticipated. To the extent that these prepaying assets were funded with duration-matched liabilities, institutions found themselves with extended liabilities against assets that had vanished from the balance sheet. The result: a need to originate lower-earning assets with older, higher-cost funding—without the ability to prepay. With the left-hand side of the balance sheet susceptible to prepayments and the right-hand side still obligated to fund at pre-specified rates, many institutions were not, as Roy Hingston characterizes in this month’s feature article, in a position to “fight fire with fire.” What could be done this time around, particularly in the case of asset-sensitive institutions? Consider taking out some insurance in the form of a returnable advance.
John Biestman is director of business development at the Federal Home Loan Bank of Seattle.
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