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August 29, 1997
Mortgage and bond yields held unchanged this week despite very strong economic data. For the first time in a long time, strong news and steady bonds did not help the stock market at all, and the Dow traded in free-fall from time to time this week.
The big news was the revision in the GDP for the 2nd quarter of 1997. Interest rates fell in late spring and early summer based on the conviction that the economy by then had slowed way down from the too-hot 4.6% pace in the 1st quarter. The initial estimate for the 2nd quarter, April-July, was a 2.2% gain in GDP, a gratifying slowdown.
Didn't happen. Some revisions in economic data are minor, but not this one: 2nd quarter GDP grew at a 3.6% pace. Worse, the newest data suggest that the economy is accelerating from there, and the rest of the year may be as strong or stronger than the first quarter.
The consequences of this growth surprise are going to be unusual.
Ordinarily, growth surprises have the same consequences for the bond market that a visit to I-80 has for Nebraska grasshoppers. This time, it doesn't look that way for bonds, and the key to the puzzle is the stock market.
For years, stocks and bonds have traded in the same direction every day -- every hour, for that matter. Good bond market, good stock market, and vice-versa. This month's "de-coupling" of the two markets signals a large change in expectations of the Fed, the economy, and interest rates.
During this month, bonds suffered a small reversal from rates in the last week in July, but are holding the low end of the May-July average. Meanwhile, the Dow is down 9.2% from 8259 to 7598 (at one point this morning), and even the less-volatile S&P 500 is down 6.5% for the month.
Why? All summer, the New Paradigm Pollyannas were selling the everything-will-be-perfect-forever snake oil, and suggesting that the Fed's next move would be to ease, to drop the Fed funds rate from its current 5.50%.
In the last couple of weeks, the Para-Pollys can't be found. If the economy is accelerating from 4.1% average growth in the first half of the year, the Fed has got to tighten, maybe as early as September.
Hence, a new equation. The Fed is already fairly tight (a hot economy cratered in '94 when the Fed tightened to 6.00%), and another notch or two will slow things down, maybe a lot. A slowdown will hurt corporate earnings and stock prices, and a couple thousand points off the Dow will put some caution in consumer spending, and slow things down even more.
Voila. Slowdowns are great for bonds. Mortgage rates may rise a little, even go back up into the eights for a while, but no major explosion, and get a lot better, later.
Sixes in '98!
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