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Commentary
“Life is like riding a bicycle. To keep your balance you must keep moving” - Albert Einstein
Dissension in the Ranks?
As we are saying in this month’s feature story, “It’s not your job to forecast interest rates, as tempting as it may be, but rather to know how badly impacted your institution may fare in a less-than-favorable interest rate, liquidity or capitalization outcome.” That about sums up the prevailing sentiment in the fixed-income markets so far this month.
As the month of October began, the spread between two-year and 10-year Treasuries came close to even. At a negative six basis points, it’s now a far cry from an inversion that exceeded 10 basis points in early September. Spreads narrowed on the heels of weakening in the long-end of the yield curve that was precipitated by well choreographed messages by various Fed governors vis-à-vis inflationary worries. For starters, Fed Vice Chairman Donald Kohn and President of the Philadelphia Fed, Charles Plosser, argued that current inflation levels remain unacceptably high and could warrant, at best, keeping rates at current levels for some time or, at worst, pushing rates higher. Remember that the Fed’s preferred measure of inflation, the personal consumption expenditures index has averaged a rate of increase of 2.5% over the past 12 months. That’s a bit above the acceptable band of 1.0% to 2.0%.
The short-end of the implied forward yield curve seems to be hemming-and-hawing over the tougher inflation talk. At last check, six and 12 months from now, respectively, the implied forward curve was predicting a funds rate some five and 20 basis points below current levels. Just last week, funds were predicted at respective rates of 20 and 45 basis points below current levels. Perhaps the markets are placing less weight on the recent statements of chairman Bernancke regarding the U.S. housing market, which he characterizes as being in a state of “substantial correction.” Further, Mr. Bernancke has framed recent inflation readings as above what he believes to represent price stability, while noting that they are likely to “come down over time.”
When Mr. Bernancke signed on as Chairman, we mentioned his proclivity toward inflation targeting as the central bank’s mandate (versus the long-operative mantra of wage and price stability). Mr. Bernancke’s former Princeton University associate, Frederic Mishkin, having just joined the Fed’s Board of Governors, is a long-time proponent of inflation targeting. A targeting mandate would represent a sharp departure from the Greenspan era, as this methodology was often interpreted as being too restrictive in the Fed’s maneuverability.
Wither the Phillips curve?
September payrolls came in below expectations, increasing by 51,000 amid a stable 4.6% unemployment rate. Not surprisingly, the bulk of the payroll increase came from the health care and financial sectors, with manufacturing employment continuing to decline.
While we’re on the subject of employment, it’s fitting to note that this year’s winner of the Nobel prize for Economics went to Edmund Phelps of Columbia University. Professor Phelps has challenged the validity of the concept of the Phillips Curve–once standard fare for baby boomers matriculating in Macroeconomics 101. As seasoned veterans know, the Phillips curve stated that there is an inverse relationship between the rate of inflation and the rate of unemployment. Much of Dr. Phelps’ work has been involved in proving that inflation does not specifically depend upon levels of employment, but more reliably, upon the degree to which households and businesses expect wages and prices to rise. Notably, he has concluded that the expectation of price increases is susceptible to going up once unemployment falls below an equilibrium rate. The key to successful inflation fighting depends upon a central bank’s understanding what that equilibrium rate is. The equilibrium rate may rise (if productivity slows) or decline (if productivity increases). As an example, Phelps builds the case that the Fed throughout the 1970’s, believed that the equilibrium unemployment rate was lower than it actually was. As a result, it inadvertently continued to maintain an accommodative monetary policy in the face of lower productivity and increased inflationary expectations.
Moral of the story: watch the productivity numbers; they’re of utmost importance to the Fed.
Asset reallocation?
With falling prices for energy, commodities, and certain pockets of residential real estate (4.42 million in unsold homes at last count, new home construction down 11.1% in the second quarter, and home sales down 10%), it may be reasonable to suggest a reallocation of capital in the direction of the equity markets. This may be true, as stocks generally outperform other asset classes when the Fed signals that it has finished raising rates. Confidence seems to be bolstered by the Fed standing pat over the past two meetings. Indeed, recent commodity price declines could portend an actual decline in the PPI and CPI, recorded for the month of September (to be released on October 17/18, respectively). In fact, Vice Chairman Kohn noted just last week that “to date there is little evidence that this correction in the housing market has had any significant spillover effects on other parts of the economy.”
In the end, equity prices are determined by the level and sustainability of corporate profits. On that score, it’s a mixed result. Profits for non-financial companies fell by 3.6%, between the first and second quarters. Financial companies, which have been reporting record profits, may face margin pressure if interest rates—and credit quality (currently at stellar levels)—decline.
With the yield curve having inverted in varying degrees over the past month, there have been reports of increases in mortgage applications, most of which represent re-financings. Last week, the Mortgage Bankers Association index of applications recorded its second highest reading of the year.
Currencies: All Quiet on the Western Front
Last month, the International Monetary Fund, in its Global Financial Stability Report, stated that the largest risk to global financial markets (surprise!) would be a disorderly drop in the dollar. Of late, pressure against the dollar has been mollified by geopolitical concerns in Asia, coupled with the fact that growth in the U.S. economy over the past year (3.6%) has eclipsed that of Germany and Japan, which have grown at one percentage point less.
Unfortunately, the current account deficit for the second quarter ($218.4 billion) came in wider than expected. Why the higher-than-expected gap? In addition to a widening trade gap, it appeared that purchases of U.S. securities by international investors slowed. For July, net foreign purchases of U.S. Treasuries, agencies, corporates, and equities totaled only $6.6 billion—a decline from the $7.0 billion recorded in June.
Adding insult to injury, the August U.S. trade deficit widened to $69.9 billion, an increase of 2.7% from July. It had been projected to narrow. On the bright side, the report indicated no weakness in imports (good for GDP prospects, bad for the current account).
On balance...
There’s no question that the housing and automotive sectors are in retreat. The consumer is no longer a beneficiary of rising housing prices and is just now coming out of a bruising round of energy price hikes. Nonetheless, non-residential outlays (largely represented by commercial building construction and manufacturing) increased substantially during the month of August and almost offset the declines that took place in residential spending. Perhaps a capital spending cycle, which does not parallel the residential real estate cycle, can support what appears to be the most likely scenario: annualized GDP growth of circa 2.5%.
John Biestman is director of business development at the Federal Home Loan Bank of Seattle.
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