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February 7, 2003
Mortgage rates are about the same, in the high-fives, though there is an ever-so-slight downward tilt, as frightened money -- war fright, and I've-lost-my-shirt fright -- finds attractive the safety and high yields of mortgages.
The hemorrhage from the stock market aside, the markets entered a kind of paralysis in late January, as war became inevitable. The newest economic data antedate this war-frozen state, and they describe an economy just barely stumbling forward, and certainly not accelerating (no matter what Mr. Kudlow says). The thin rebound in manufacturing looks like overdrawn-inventory pipeline-filling, supported by profitless manufacturing of cars. Today's employment report, appearing to show new hiring in January and a decline in unemployment, was a transparent statistical quirk; its upward pressure on interest rates lasted barely an hour this morning.
The internal erosion in corporate America stands out in two statistics. First, in the last two years, the economy has lost two million jobs, and in the last six months, about a million people have stopped looking for work altogether. Layoffs continue at the same pace, and the new-job market is flat.
Second, office vacancy rates continue to climb -- not from excessive construction, but internal contraction. The tip-off: an all-time high in offers to sub-lease space, as existing tenants try to unload. Behind that stands a huge, poised wave of "shadow space," empty but not yet on the market. (If a publicly traded corporation seeks to escape lease liability, it must record a write-off; most would rather absorb the ongoing hit to cash flow. And you thought corporate America had come clean....)
I'll grant that the stock market types are right that war is a partial cause for the decline in their prices, but I can't make the leap that once the war is resolved, we will enjoy a stock rocket. Consider: if the economy were on an accelerating slope of growth, would stocks be so badly hurt by impending war?
The bond market is in another philosophical place altogether. Certainly, war-nervous investors help to keep rates down, and bond market types know full well the economy's fragile and unrecovered condition.
However, bond types have two fears all their own: first, rising deficits, which at minimum mean that the Treasury will be selling hundreds of billions in new bonds ($45 billion next week, for starters). However, their deep fear is "reflation."
To "reflate" is to induce a rise in prices and the level of economic activity after a period of deflation or recession. It is the exact opposite of the Fed's normal duty to suppress inflation and maintain a stable currency. So, why don't we just say "inflate" instead of reflate?
Because it explains our predicament. The rate of inflation increased from near zero in 1960 to roughly 10% annually by 1980-1981, and has fallen ever since. Although the inflation rate fell during the last twenty years, there still was some inflation. Until this last year, when there was either none, or incipient deflation. Bond types assume that there is no way out of this price gravity-well except new-found inflation. Reflation.
The gods of bonds assume one of three mechanisms, or all in concert, will do the reflation trick: vast deficit spending, or a dollar crash, or the Fed will print a great deal of money (perhaps by buying itself a lot of the new Treasury bonds). Therefore all good bond types are poised to sell everything at the first sign of reflation. As none of these worthies has ever experienced a deflation/reflation cycle, they are excitable.
Although I don't think we're in for a dollar crash or a new inflation cycle, we are overdue for a period of interest-rate volatility -- true up and down, not just up -- that we haven't seen in years.
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