Bucking the Global Trend
In contrast to subdued economic indicators emanating from Western Europe and Japan, U.S. consumers appear to have increased their levels of optimism. Now standing at 94.8, the University of Michigan consumer sentiment index for the month of June reached a five-month peak. June’s increased consumer confidence coincided with continued non-farm payroll growth of 146,000 workers and a reduction in the jobless rate to 5.0%. Notably, the reduction in the unemployment rate occurred in the face of a rising labor participation rate. Thus far into 2005, payroll growth has averaged 181,000 jobs per month. This rate is comparable to 2004 levels, when GDP had grown at the fastest rate since 1999.

The retail and manufacturing sectors of the American economy are also showing signs of life. In spite of rising gasoline prices, June sales extended well beyond predictions for most national retailers. The Institute for Supply Management’s Index of Manufacturing increased in June from 51.4 to 53.8, for the first time in seven months.

Reports of manufacturers of consumer-packaged goods attempting to invoke price increases continue to mount. Manufacturers such as Procter & Gamble, Clorox, Kimberley Clark, and Gillette have announced price hikes in the wake of rising raw material prices. Whether or not larger retailers will be able to defend these increases remains to be seen. The same holds true on the issue of whether consumers will substitute and trade down to private label goods. Still, during his June 9 remarks to Congress, Mr. Greenspan spoke of “some evidence that pricing power has been increasing.”

As we did in last month’s issue of What Counts, let’s compare this picture with current conditions in Australia and the U.K., where fixed-income yields exceed those of the U.S. In the wake of tighter monetary policy and central bank outspokenness regarding lofty valuations, housing prices are now starting to decline in these locales. No doubt, the Fed (now the world’s only major central bank in the midst of monetary tightening) understands the fine line it is treading, especially given that over 40% of job creation in the U.S. has emanated from manufacturing and service sectors that are related to housing. We’ll likely gain further insights into the Fed’s view of economic growth prospects on July 20 with Mr. Greenspan’s semi-annual delivery of the monetary policy report before the House Financial Services Committee. The market’s guess as to future Fed funds levels for the end of the third and fourth quarters (as measured by the respective September and December Eurodollar Contracts at 3.92% and 4.11%, less the historical difference of 23 basis points with Fed funds): 3.69% and 3.88%.

10-Year Cycle?
There are some interesting parallels with the Fed’s actions and the economies of 1985 and 1995.

After recovering from recessions early in the decade, 1984, 1994, and 2004 all represented periods of strong economic recovery and commensurate corporate profits and equity returns. Then in 1985, 1995 (and perhaps in 2005?) the Fed tightened the monetary reins and slowed economic momentum in an effort to contain inflationary expectations. In both cases, a mid-cycle slowdown reverted to further economic growth within several quarters.

To be sure, inflationary expectations have increased due to several factors: oil trading north of $60 per barrel, housing prices, and escalating unit labor costs (caused, in part by escalating health-care benefit costs). The Fed is watching the inverse relationship between labor costs and productivity (See Figure 1.) Perhaps these variables, more than any others, will ultimately determine the point at which the measured march to higher short-term rates is halted. Still, two significant counters to inflationary momentum remain: growing worldwide labor-capacity and stagnant money supply.

Figure 1. Non-Farm Business Productivity Annualized Growth vs. Business Unit Labor Cost Annualized Growth

Our monthly implied-forward yield curve analysis shows negligible differences between current and future expected yields in the two-year sector and beyond. Shorter-term, markets are anticipating that the Fed will cease its campaign in the vicinity of 3.75%. Levels of longer-term rates could play a role in the Fed’s timing. If the Fed perceives lower longer-term rates as due to an international “savings glut,” Mr. Greenspan could see the persistent “conundrum” as hampering the effort to prevent inflation. The natural response: continued tapping of the monetary brakes. With many economists forecasting 10-year yields to barely exceed the Fed Funds rate into 2006 and the fact that U.S. long-term rates are among the highest in the world, the possibility of an inverted yield curve cannot be totally discounted. As now practiced in the Seattle Bank’s Strategies for Success workshops, it may not be a bad idea to simulate your operating results under such a scenario, rather than modeling strictly under the assumption of parallel shifts in the yield curve.

The Fed’s tightening stance over the past year is reflected in the money supply data. As demonstrated in Table 1, M1 has been virtually stagnant over the past six months.

Table 1. Annual Percentage Change: Seasonally Adjusted, Money Stock Rate-of-Growth

Figure 2. Money Stock Measures 6/03 - 6/05

“There's no business like show business, but there are several businesses like accounting.” – David Letterman

Much to the relief of many a portfolio manager, the Financial Accounting Standards Board has recommended jettisoning key proposed elements of EITF 03-1. As we discussed in our October 2004 issue, the proposed standard would have redefined the valuation impairment of securities, as well as the timing of when such impairment would be recognized. As proposed, EITF 03-1 would have restricted the use of securities portfolios as asset/liability management tools. The initial rule would have required institutions to write down entire available-for-sale portfolios in the event an “available and intent to hold” security was sold at a loss. Additionally, the rule would have required institutions to flow paper losses on securities through to the income statement in the event they could not prove that they intended to hold those securities until the loss was recovered.

In response to the proposed directive, many institutions had been reducing trading activity, shortening portfolio durations, and/or investing in longer-duration, less-liquid whole loans. No doubt, the vociferous and organized public comment process played a significant part in derailing the proposed standard.

John Biestman is assistant vice president, IMS consultative sales advisor at the Federal Home Loan Bank of Seattle.

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