29 Sep 2006 Bonds Say Hard Landing – Stocks Say Soft?
As the Dow nears its all-time high, the economy is slows. The Commerce Department reported today that personal income increased again in August by .3%, consumption increased by only .1% following a .8% increase in July. But after adjusting for inflation, spending actually fell.
The Fed is on hold, but some wonder if they are finished. Core inflation is at an 11-year high and about a half percentage point above the level some Fed officials have said marks their comfort zone which is between 1 and 2%. The market-based core PCE price index grew 2.1% in August compared with a year earlier after rising 2.0% in July. But, other Fed officials have pointed out that inflation always peaks after the Fed stops its tightening program and falls as the economy slows, as it is doing now.
According to the WSJ, the Federal Reserve watches the year-over-year index for signs of excessive inflation; the central bank’s comfort zone for this gauge is considered to be 1.0% to 2.0%. But with income growth and spending both slowing, the pressures on inflation should diminish in the coming months. In fact, economists at Citigroup think the Fed will lower its benchmark rate as early as the first quarter next year. Merrill and Goldman have both said they expect the rate drop to occur before June.
Today’s Chicago Purchasing Managers Index quelled some fears that the economy was slowing too fast. The report indicated that companies were not overreacting to signs of a slowdown in the housing market with drastic cutbacks. The simultaneous slowdown of housing (hence the consumer) and business might deliver the hard landing that some, including bond investors, fear.
The recent strength in stocks has not been mirrored by bonds, but that may be temporary. US Bonds may continue their price advance along with European and Asian bonds (pushing yields down) as oil prices fall. Rates are declining globally as oil prices drop and as the pace of global growth slows.
The third quarter earnings pre-announcement season is approaching and will soon know more about the strength of business. So far things look pretty good. Robust U.S. productivity growth is likely to persist “for some time,” providing continuing support to the U.S. economy and living standards, Federal Reserve governor Randall Kroszner said Wednesday. “The rate of technology growth appears to be proceeding apace and further diffusion of already existing technologies and applications to more firms and industries should continue to boost productivity.” The WSJ reports that economists have pegged the annual productivity growth trend at 2.5%, which is nearly as strong as that during the 1995-2000 period.
Stock investors believe that the economy will not slow too much or too fast and they believe that the Fed will “do the right thing” and begin easing interest rates sooner rather than later. At the moment bond investors are taking the opposite bet. Time will tell who is correct.