08 Jul 2005 Not Too Hot, and Not Too Cold

The economy is growing fast enough to create jobs, but not so fast to cause significant inflationary pressures.  The nation’s unemployment rate dropped to 5% in June from 5.1% in May.  Cutbacks at auto factories kept the payroll growth of 146,000 new jobs, below the expected 200,000, but the last two months’ job growth numbers were revised significantly upward, improving the job growth picture. 

Job gains are providing consumers with more confidence and spending power which is counterbalancing the negative effects of higher fuel costs.  Earlier in the week theUniversityofMichigansaid their consumer confidence survey results increased for the first time in seven months, bucking the negative sentiments of high oil prices.  The Federal Reserve last week said the economy “remains firm” in spite of unusually high crude oil costs.  Today’s report showed that the economy created 542,000 jobs in the second quarter, compared to 546,000 in the first quarter and 569,000 in the fourth quarter of last year.  That’s consistency.  The service side of the economy continues to be responsible for the job growth while manufacturing continues to struggle, but shows signs of improving.

U.S. Treasuries are little changed on the day, indicating the jobs report was pretty much as expected.  The stock market at the opening looks like it will sustain or improve upon yesterday’s rally after declining as much as 3% following the terrorist bombings in London.  Almost in spite of the tragedy markets showed rather remarkable resiliency and calm.

Current market trends suggest that stock investors are buying on the dips (indicating higher confidence and ensuing rising stock prices) while bond investors are selling the rallies (suggesting lower bond prices and higher interest rates).  If long-term interest rates rise by a quarter to a half a percent, it will give the Fed a little breathing room to continue their rate increases without risking inversion of the yield curve.

What’s a yield curve and why is inversion a problem?

The yield curve is a chart of the yields of bonds of the same quality (in this example U.S. Treasuries) and gradually lengthening maturities.  We currently have a positive yield curve, pictured below, with higher rates as we extend the maturity range.  Investors demand higher rates for longer maturities as the risk of inflation rises with time.

But we’ve seen the yield curve flatten lately.  The yields on longer-term Treasury securities such as the 10-year note have fallen over the past year, even as shorter-term rates, such as the Fed’s key short-term rate, the fed funds rate, or the 3-month Treasury yield, have steadily gained ground.  History tells us that as short and long rates get closer, slower economic activity is almost sure to occur.  If short-term rates rise above longer-term rates, a recession is virtually always in the offing.  The last time the yield curve was inverted was from July through November 2000, right about when the last recession began.

What’s puzzled Mr. Greenspan has been that bond investors have had a huge appetite for long-term bonds, sending their yields lower in the face of rising short-term rates.  They traditionally rise together.  The idea is that if the Fed is fighting inflation, bond buyers should demand higher rates for long-term bonds.  But until recently bond buyers have been convinced that the economy was not growing fast enough to create inflation and have been betting with their money.

But even with the recent rebound in the 10-year yield from 3.9% to 4.1%, the gap between the weekly averages for 3-month and 10-year Treasury yields is only 0.88 percentage points – the narrowest gap since December 2000.

Here’s why all this matters.

When there’s a large gap between short and long-term rates, financial services firms can make fat profits by extending credit, fueling economic growth.  On the other hand, when short-term rates are equal to or higher than long-term rates, the lifeblood is squeezed from the economy.  Lenders are deprived of profitable operations, discouraging capital creation.

But Mark Vitner of Wachovia Securities says “it really depends on when you get the flat curve.  Right now with the low rates, I don’t see dire implications from a flattening yield curve.  It just is accurately indicating that the economy is slowing or moderating.” Vitner said even if there is an inverted yield curve at these levels, it wouldn’t necessarily mean a recession as long as long rates didn’t drop too far below short-term rates, or stay lower for too long. He puts the risk of a recession at roughly one in six.

Bernard Baumohl, executive director of the Economic Outlook Group of Princeton,N.J.agrees and adds further reasons not to worry.  He said when the spread between long and short rates narrows, but both remain below 4% it’s “just not problematic for an economy with a low underlying rate of inflation and still healthy productivity growth. There’s still plenty of liquidity out there and the cost of capital remains relatively cheap.”

An additional cause for rising bond prices was the unusual ‘flight to quality’ caused several weeks ago by General Motors and Ford’s bonds being downgraded to junk status.  Also, the U.S. economy is growing faster than most other global economies and foreign money center banks are buying U.S. bonds as the dollar rises.

It all comes down to what the Fed will do with rates.  If they insist on continuing their rate increases much further (say above 4%), they risk derailing the economy’s growth.  From their talk, more rate increases are on the way and it appears that bond investors are finally facing that reality, taking rates higher.  We’ll be watching.