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May 20, 1988
Interest rates rose this week in panicky fashion, and out of proportion to Fed tightening. Economic data described a steadily growing economy, but not explosive growth. Industrial Production rose .7%, Capacity Utilization rose .4% to 82.7%, Housing Starts rose .5% (bouyed by a temporary surge in multifamily starts), Building Permits fell 4.1%, and The Consumer Price Index rose a modest .4% this morning.
The big action followed the Trade Deficit release on Tuesday, which showed a spectacular reduction to the $9.75 billion range. The bond market shot up over a point in happy reaction, and then hit an iceberg when the improvement in the trade numbers was discovered to be entirely from a surge in exports (as opposed to a decline in imports). The export growth frightened investors concerned that we will have a fullscale boom on our hands. Anyway, that was the "explanation" offered for a bad reaction to a good number.
The credit markets are driven in the short term by expectations of Fed action, and for that reason, reading the economic tea leaves is worthwhile (because that's what the Fed does). In the long run, the relative supply of buyers and sellers drives the market, and that relationship is neither very rational nor predictable. The market crashed this week because it is feeling panicky, not because of any particular data. The Fed has tightened Fed Funds to the 7.125% range, and the Chairman is probably perplexed that the tightening has not reassured the bond market's inflation fears. The Fed may raise the Discount Rate (the rate at which banks borrow from the Fed) as early as today, but it and the Prime Rate are largely cosmetic affairs that get big play only in the newspaper.
It seems to me that rates have risen fast and a lot, and we are due for a correction or a plateau fairly soon. The panic tends to wash out of the market when everyone who has a bond to sell has sold, and only buyers remain (the reverse applies in an overbought market). I was too optimistic last week, and may be again, but if the Fed doesn't hit us again, we are due for an improvement in rates. If we don't get an improvement, we're due for a recession maybe before the end of the year.
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