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September 16, 2005
Bond market conditions changed abruptly for the worse, the 10-year rising from 4.12% to 4.27% overnight, mortgages moving toward 6.00%.
The shift is not yet a total breakdown: in the last year the 10-year has been in a wide, sloppy range from 4.00% to 4.40%; having tested the bottom for the last 45 days, a move back to the middle is routine. However, bonds reacted to news in unusual ways, suggesting that something bigger than range-wandering is going on.
There were two out-of-pattern reactions to news. The largest bond move immediately followed release of a Philadelphia Fed survey on Thursday: economic activity in Mid-Atlantic states had crashed in August, while prices for materials doubled. For most of the summer, bonds have liked news like this, ignoring the inflation component in favor of enjoying the pre-recessionary aspects. Not yesterday.
This morning, the second oddity: the University of Michigan’s consumer confidence reading for early-September arrived at 76.9, the lowest reading in more than a decade. These confidence surveys are not the best economic predictors, and Katrina dragged this one down, but bonds always improve on a bad one. Not today.
The trading pattern says that the inflation/Fed calculus has changed. Long-term rates broke lower in August on conviction that the Fed’s anti-inflation campaign would produce a slower economy next year, and maybe a recession. The signature then: a closing spread between the Fed-sensitive 2-year T-note and the 10-year. As the 10-year dropped from 4.40% to 4.10%, the 2-year rose to 4.00%, predictive of an “inversion” (the Fed rate, now 3.50% to rise above bonds) not far above 4.00%.
In the deterioration underway now, both 2s and 10s have risen in anticipation of a tighter/higher Fed, but the 10s have pulled away from 2s, the spread tripled at .36%. The move says (shouts) that inflation is a bigger problem, will be harder for the Fed to contain, and a slower economy is less likely and/or farther away. Any recession-precursor inversion will be higher in the fours.
Also, the President’s speech was a double whammy for bonds: the $62 billion gushed from Congress last week for New Orleans was only the first installment of a reconstruction cost now likely to exceed $200 billion. That means economic stimulus frustrating the Fed’s slowdown efforts, and also a hell of a lot of new bonds for sale.
Inflation has probably crossed an unhappy threshold. The first waves of energy-price increases were absorbed in healthy gross margins at business, and adaptation and fuel substitution. The increases now are so big that they are washing through to the cost of everything: natural gas is up 40% and will stay up (partly Katrina, mostly Green and super-safety-freak objection to LNG terminals for imports).
Three-buck gasoline seems to have been a tipping point. Good news: forced conservation, though it will take a while to move prices and supply. Bad news: rising costs for everything. My firewood guy of 25 years, gravel-voiced, straight-shootin’ Nick, this week: “Lou, it takes gas to cut it, gas to move it, gas to split it, and gas to deliver it. Two-twenty last year is two-ninety-five... if you stack it.”
In the last 48 hours, gold reached a 17-year high, breaking $460.
The Fed has no choice, now. Its rate will go 3.75% to on Tuesday, then two more .25%-ers before year-end, and another at Mr. Greenspan’s last meeting on January 31. Why Mr. Bush has not nominated a replacement -- choosing a person likely to reassure markets -- is beyond me.
A rate-suppressing weakness in consumer confidence has been overwhelmed by a different confidence issue. The newest polling data says the country thinks the Bush administration is in over its head from New Orleans to Iraq, and a failure of confidence in the bond market makes rates go up, not down.
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