Commentary

The past month’s fixed income market continued to focus on the usual suspects: inflation (or lack thereof), a moribund labor market (relieved by September’s 57,000-person increase in payroll employment and upward revision of August’s numbers) and ongoing policy-speak from the Fed. Nevertheless, a new variable has appeared on the scene: speculation that Asian central banks may decrease their U.S. Treasury holdings in the face of rising supply.

State of Inflation
On a year-over-year basis, August’s 1.3% increase in the Consumer Price Index represented the smallest rate of increase since 1966. Except for the least price-elastic components on the shopping list (e.g., higher education, gasoline and prescriptions), most sectors of the economy continued to have difficulty pushing price increases to the consumer. Labor costs continue to moderate; in recent talks with the “big three” auto makers, the United Auto Workers (UAW) appeared willing to sacrifice past wage gains in exchange for preserving favorable health benefits.

The GDP Speed Limit
Our composite average of economist forecasts of GDP shows levels for the third and fourth quarters of this year to be 4.8% and 3.6%, respectively. Some economists predict third-quarter growth to be as high as 5.7%. We’ll see if this growth rate continues into the fourth quarter. Some would argue that third-quarter growth was attributable to non-recurring positive factors: a housing sector lifted by “fence-sitters,” child-credit checks in the mail and auto incentives.

With growth rates like these, it’s worthwhile to explore the “speed limit” question: at what point will the Fed alter its stance should the GDP growth needle push into the red zone? The answer primarily depends on long-range levels of productivity and employment growth. Although the latest release of second quarter GDP statistics recorded productivity levels of 6.8%, the expected average over the next 10 to 20 years is currently 2.25%. Historically, employment growth at 1.0% plus productivity growth at 2.25% has equaled the GDP-growth speed limit of 3.25%. This economic speed limit, generally perceived to be the economy’s long-term, sustainable, non-inflationary rate of growth, has increased from 2.0% early in the last decade to 3.25% as estimated long-term productivity improved.

Historically, when GDP growth exceeded the economic speed limit long enough to absorb any underperformance or “slack” from prior periods, the Fed would tighten short-term rates. This is what happened in 1994. With an economic growth rate of only 1.6% over the last 2.5 years, we’ve accumulated a significant amount of slack; GDP growth would have to significantly exceed the speed limit for a considerable period to absorb it. Currently, GDP growth is essentially surging forward on only one cylinder—productivity growth. Until labor force growth becomes a contributor, the probability of upward pressure on the Fed funds rate appears limited.

The Fed
During the September 16 Federal Open Market Committee meeting, the Fed characterized the economic recovery as needing more time to counter a “weakening” job market. Fed officials continue to discuss the probability of inflation as “undesirably low” and believe that “policy accommodation” can be maintained for a “considerable” period. These statements are backed by recent statistics on money growth—money supply measures continue to grow at an annualized rate of approximately 8%.

Dubai or Not-Dubai?
During the weekend of September 20 – 21, “G-7” finance ministers convened in Dubai. In concluding remarks, they stated, “flexibility in exchange rates is desirable for major countries… to promote growth and widespread adjustments in the international financial system.” Not an earth-shattering communiqué, at least on the surface. But, consider the following:

 U.S. government securities held abroad: $1.39 trillion
U.S. government securities outstanding: $3.45 trillion
Foreign official and private holdings of U.S. government securities in Japan: $443.8 billion
Foreign official and private holdings of U.S. government securities in China: $126.1 billion
Combined Japan/China share of U.S. government securities as a % of U.S. securities held abroad: 41%
Total sales of yen by Bank of Japan (first seven months of 2003): 9.03 trillion ($80.4 billion)
September combined monthly auction of two-, five- and 10-year U.S. government securities: $54 billion.

*US Treasury: Major Foreign Holdings of Treasury Securities

What are the implications? Prior to the Dubai conference, Bank of Japan was likely taking the proceeds of yen sales and purchasing U.S. Treasury securities. In the past, the market has viewed Asian central bank purchases of U.S. dollars as a good source of support for Treasury auctions of increasing size. While Japan’s year-to-date sales of yen have been roughly equivalent to one and a half months of U.S. Treasury auctions, the market is fearful that a reduced dollar-buying program in the face of rising U.S. borrowing requirements would affect bond prices at the margin. The situation could be exacerbated by a continued slide in the dollar, as foreign investors convert their holdings into home currencies. Bank of Japan did not help matters by refusing to defend the dollar at the key 115-level after the meeting. Yen/dollar is presently trading at just above 109.

A Continued Steep Yield Curve
The fixed income markets had been trying to make it out of the doldrums. Until last week, they’d rallied for six consecutive weeks, a feat not accomplished since September 2002. Prices had been bolstered by declines in the NASDAQ, the dollar, consumer confidence indices (Conference Board consumer confidence index for September the lowest since March), and weaker-than-expected personal spending and retail sales. Nonetheless, the third quarter’s closing yield on the 10-year treasury increased by 43 basis points, to 3.94%, compared to closing levels at the end of June. This is the largest increase in yield since the fourth quarter of 2001. During the third quarter, the yield peaked at 4.66%.

Risks to overall growth remain: weak employment, the non-recurring nature of economic boosts (e.g., child credits, residential refinance) and declining equity prices. But, in addition to the favorable employment report, there are other positive signs for the economy that may place upward pressure on rates. In the capital goods sector, the Business Week industrial production index posted a significant increase to its highest level since 2001. First Call earnings revisions (i.e., the aggregation of equity analyst estimates) continue to trend up.

The yield on the three-month eurodollar contract is currently down 50 basis points from September 1. This is yet another indication that the short-end of the yield curve continues to trade in its own orbit. Since our last issue, the yield curve has flattened, with the one-to-10-year advance curve shifting from 368 to 352 basis points. Nonetheless, recent signs of positive economic news, pressure against the dollar and ongoing U.S. Treasury issuance suggest the yield curve will continue to be very steep by historical standards.

John Biestman is an IMS Consultative Sales Advisor at the Federal Home Loan Bank of Seattle.