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May 6, 2005
News of surprising strength in employment has this morning intercepted a week-long bond-market attempt at lower yields. Mortgages headed below 5.75% are now headed above, taken by the 10-year T-note's retreat from 4.15% to 4.25%.
I am amazed that this week's data have not done more harm to rates. In today's numbers, April payrolls rose by 274,000 versus 175,000 forecast, and the prior two months' figures were revised up another hundred grand; more serious is news of a .3% gain in average hourly earnings. Negligible growth in wages has been the crucial suppressant of inflation, keeping it low in spite of an energy-cost conflagration. Today's average-earnings report annualizes to 4% growth, and confirms the 1st quarter leap in unit labor costs to 2.2% in from only 0.4% in 2004.
There are signs of a slowing economy, especially in the indices from the purchasing manager's association (the manufacturing one has trended down for a year). S&P's downgrade of GM and Ford to junk status accurately reflects their drag on the economy, and pushed scared GM and Ford bond money to safe Treasurys and mortgages. However, overall auto sales were strong in April.
US Treasury tax receipts continue to surprise on the upside, in the aggregate running $75 billion ahead of forecast. In the absence of any funny-money receipts (such as '98-'00 dot-com, IPO, and option-sale revenue bloat), that's a hell of a performance for an economy supposedly in a pronounced slowdown.
The global economy is slowing, Japan in (another) recession-deflation spiral; Europe on the edge. Our bonds and mortgages are supported by an absence of other places to invest: Japan's 10-year trades 1.23% today, and Germany's pays 3.45%. The European Central Bank is holding its equivalent to our overnight Fed funds rate at 2.00% for fear of wrecking the Eurozone economy, though its inflation rate has risen to is 2.1%. Asia's non-Japan economies are slowing, too, but going from 8% growth to 7% is more baseline wobble than meaningful slowdown.
(A non-story note: reintroduction of the 30-year T-bond is a technical matter that will not harm interest rates, mortgage or otherwise.)
Over the last month the bond market has become convinced that the combination of economic slowdown and Fed tightening in place and to come means 1.5-2.0% inflation is a safe bet, and therefore T-notes at 4.25% have value. Value with a kicker: Fed hyper-vigilance increases the odds of recession or recessionette, in which case bond traders might make a lot of money in a yield decline to 3.75%.
This consensus has further convinced itself that the Fed is going to stop at a 3.50% Fed funds rate, after hiking .25% on June 30 and again August 9.
I may be the last man waving a wait-a-minute flag, but here goes. Long-term bond investors think long term (duh), and therefore theoretically should not care how tough the Fed has to get in order to stuff the PCE back under 2% inflation (up to 2.2% in the 1st quarter) and to prevent widespread cost-pushed price increases from percolating into much-harder-to-control wage increases. However, I think this bond market is totally unprepared for the thought that the Fed may have to keep right on going past 4% Fed funds to keep inflation contained.
The Fed says that it is still "accommodative", which means easy, below "neutral", and still stimulating the economy. Its 2% cumulative hike is thus far is not exerting brake pressure, just backing off the gas pedal of an economy running downhill. The Fed may not be able to pause at neutral -- coasting will not contain inflation.
I may make too much of it, but the prior-meeting line the Fed dropped from this week's post-meeting statement says more than the ones it printed: a month ago, the Fed said that energy costs had not caused other prices to rise. The line is gone, and widespread price pressure is here.
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