15 Aug 2003 The Bond Market Believes
Stock investors earnestly began to believe that the U.S. economy was in recovery on March 12th. Microsoft and Intel were among the volume leaders that day as major headlines read “U.S. stock indexes have biggest gains in five months.” Sparking the rally were comments from the administration indicating that it would extend diplomatic efforts to disarmIraq, effectively delaying the war. In the following days many analysts characterized the good market action as a short-term reaction to news war delay, but time has shown know that investors were looking at the larger picture and anticipating economic recovery beyond the war.
Bond investors, more conservative and credited as being right more often than stock buyers, weren’t ready to capitulate. It is generally expected that with economic improvement, interest rates rise as the demand for money increases. Inflation generally increases too as sellers of goods and services can increase prices when demand exceeds supply.
But, even in the face of historically low interest rates due to war concerns, investors continued to demand the safety and dependable income stream offered by bonds even as stock market investors were becoming convinced of an economic turnaround. In the months following the March stock market rally, talk of ‘deflation’ and an accommodative Fed policy pushed even more investors into the dramatically overbought bond market.
The chart below demonstrates several things. It is comprised of two lines; the orange denotes the average price of long-term treasuries (over 20 years). The relatively flat black line shows the less volatile short-term treasuries (less than three years to maturity). As bonds extend in maturity their sensitivity to interest rate changes increases significantly. As rates rise, the value of long-term bonds falls considerably faster than the value of short-term bonds. Note that the long term treasury index is down 15.6% since June 16th, while the short-term index is down only 1.1%.
Look to the far left of the chart at the orange line first. It shows a steady rise in prices for long-term treasuries from the first of the year as the looming war with Iraqgrew more intense and deflation fears increased. Notice that in mid-March, when the administration delayed the war, bond prices began falling just as stock prices rose. This was a normal pattern as investors sold bonds to buy stocks. In just a few days bonds had given up the ‘war premium’ part of their prices garnered over the past several months. But on March 18th after the Fed left rates unchanged and said they could not assess the outlook for the economy, bond buyers came back in force and began driving bond prices up again. Bonds continued to rally until mid-June when a much more significant change occurred.
On June 16th the New York Federal Reserve reported in their Empire Manufacturing report that manufacturing in that state had expanded significantly more than economist expected. The S&P 500 index closed above 1000 for the first time in a year and Treasuries began a slide that has not slowed yet. Look at the steady decline in prices after mid June demonstrated by the orange line. The black line, representing short-term treasuries shows a decline from the same starting point, but is significantly flatter indicating less loss of value.
International investors also believe the recovery in theU.S.is real. The Dollar-Euro exchange rate staged a sharp reversal in mid-June and began an ascent that continues today. The chart below tells the story.
Recovery on Track
The steady decline of the orange line since mid-June provides a clear signal from the bond market that the economy is in recovery. Corporate earnings reports for the second quarter overwhelmingly confirm economic improvement. The stock market, which anticipated the recovery well before the bond market and actual corporate earnings, is now largely in a holding pattern. Since reaching the 1000 point mark in mid-June the S&P has been flat to slightly down. The NASDAQ has been more volatile and is now slightly above its mid June level. The equity market will likely continue to largely bide its time until earnings reports come out again in the fall, moving modestly as general economic numbers are released by the government.
Those fearing deflation were relieved on Tuesday and Wednesday when inflation indicators showed modest price increases at the import and producer levels. Until now, companies have been unable to raise prices in the face of falling demand and forced to let workers go to cut costs. During the past several weeks, that trend appears to be reversing. Initial jobless claims continue to be below 400,000 which indicates to economists that the economy is beginning to create jobs again. The continuing claims report also showed improvement.
Today’s consumer price indexes confirmed what is going on at the producer level – prices are rising, and that’s good news. Deflation fears should continue to dissipate.
This morning the New York Fed reported that the Empire Manufacturing index was at 9.98. Unfortunately the reading was below expectations of 20.0, but it still shows improvement in manufacturing in that state. Industrial Production and Capacity Utilization have become two of the more important numbers to watch. Released just minutes ago, they each showed modest improvement. Industrial Production increased a half a percent after changing little in the past two months. Manufacturing output rose .2% after gains in May and June. Capacity Utilization (the amount of factory use) rose .3% to 74.5%, a rate 6.8% below the average from 1972 to 2002, according to Bloomberg.
Choppiness and slowness continue characterize this recovery, but we ARE in recovery, nevertheless. While every twist and turn is important, we remain focused on the big picture. Corporate earnings, the stock market, the bond market, and the dollar are each telling us that recovery continues. The economy is stronger than most believe. If stability can continue for a few more months, confidence will build and the most important phases of the recovery will start – business investment and job creation. By the time those trends are apparent to all, the stock market will once again be the investment vehicle of choice and much of those three trillion dollars in cash currently on the sidelines will be chasing the stocks of the country’s best performing companies. We believe we already own many of them.