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July 29, 2005
Beware good news... very strong economic data are today pushing mortgage rates higher, fixed-rate 30s still under 6.00% for the lowest-fee packages, but just barely. ARMs are under even more pressure, as the intermediate 5-, 7- and 10-year hybrids are all between 5.50% and 6.00%.
This morning’s report of 3.4% GDP growth in the 2nd quarter understated the true strength. Business “final sales” leaped 5.8%, the variance above GDP largely filled by a draw-down of inventories; the resulting inventory shortage all but guarantees a boost in production and fast growth in the next quarter.
Other data confirmed the healthy pattern: orders for durable goods in the 2nd quarter raced ahead at an 8.3% annual rate, double the 1st quarter pace. Although icon companies (Kodak, HP) continue to announce big and permanent layoffs, new claims for unemployment insurance have fallen near the 300,000 mark, and the newest (excellent) housing data reinforced the National Bubble Watch.
The inflation figures in the GDP report were fine: the employment cost index rose .7% in the quarter, a little below the year-over-year 3.2%. Also, the best overall inflation measure, the core personal consumption expenditure deflator (“PCE”) rose at a calm 1.8% annualized, safely below the Fed’s 2% trouble zone.
Boiled down, the data support Mr. Greenspan’s testimony two weeks ago. (We have all enjoyed second-guessing him, and “Ah-HA”-ing at his handful of errors, but the main sensation during his 18-year term has been, “Damn -- how did he figure that out so fast?) While financial commentators everywhere were still pointing to a global excess of labor and production capacity, the Chairman saw a gradual reduction in that excess toward an inevitable conclusion: the economy is going to run into capacity constraints, and it’s the Chairman’s job to make sure that we don’t hit those limits at high speed.
Yeah, there are a billion-some workers in China and India coming on line, but they can’t do so all at once. Their current productive capacity is already straining against available electrical power, transportation, and infrastructure. There is excess industrial capacity for things like automobiles, and technology, but other signs that most of the productivity-enhancing aspects of today’s technology have been deployed. The theoretically weak American labor market is not; jobless claims falling near 300,000 is exactly the “reduced slack” that the Chairman pointed to.
The bond market got the message, and the current shape of the yield curve is a fascinating and still-developing forecast. The 10-year T-note has risen a half-percent since June lows, to 4.29% today, but is still a half-percent below its level when the Fed began to tighten. Trading anywhere in that 3.90%-4.80% band, the 10-year is an overwhelming forecast of low inflation and slower economic growth ahead.
Meanwhile, the middle of the Treasury curve has exploded, and there is no conundrum as to why: the Fed is coming, and coming hard. In three weeks the 2-year T-note has gone from 3.58% to 4.00%, and the 5-year from 3.67% to 4.14%, pricing in Fed moves to 3.50% on August 9, and 3.75% on September 20.
Many observers are still looking for an “inversion”, short rates rising above long, but I think it more likely that the whole yield curve will move up from here in one piece, current spreads intact, roughly a quarter-percent every 45 days as it becomes clear that the Fed does not intend to stop at 4.00%, or perhaps even 4.50%.
The tip-off: we no longer hear the word “neutral” from the Fed. Used to be, the Fed was raising its rate just to get back to a post-bubble neutral; now... now it looks as though we are in sight of the limits to 4% GDP growth. In traditional inflation pre-emption, the Fed will keep going until it gets clear signs that the economy is slowing to sustainable speed.
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