A New Year Of Living Dangerously With Higher Interest Rates
John Lonski, Moody's senior economist in New York
The Fed's late-1998 efforts at enlivening US expenditures exceeded expectations in terms of their stimulatory effect. Could it be that
the latest upturn by short- and long-term interest rates will subtract more from US economic activity than is currently anticipated?
The US' often overlooked record current account deficit adds to the risks of especially burdensome interest rates.
In the week of the new millennium, interest rates soared higher in anticipation of both faster price level growth and Federal Reserve
rate hikes. In late-1998, the US economy received an extraordinary boost from the lowest bond yields in 30 years, including efforts
by the world's major central banks to spur global expenditures. At the start of 2000, no longer does the US economy receive a
special lift from low borrowing costs. Far different from a year ago, now the Federal Reserve's policy intent is to slow the US
economy.
A higher level of indebtedness is likely to be troublesome for the US economy if steeper borrowing costs curb expenditures
significantly. Provided that refinancing risks are well contained, higher levels of debt do not necessarily weaken credit worth. Of
greater importance is the adequacy of debt repayment capacity, which consists of the income from which interest and principal are
to be repaid and the collateral that backs outstanding indebtedness. A steep enough climb by interest rates can lessen credit worth
by diminishing income and paring the market value of collateral.
The latest jump by the now 6.54% 10-year Treasury yield relative to the 5.5% federal funds rate target supposedly reflects an
improved outlook for economic growth. However, the proximity of the 10-year Treasury yield to the 6.56% 30-year Treasury yield
warns of a slower economy. When the 10-year Treasury yield last climbed sharply higher relative to the 30-year Treasury yield in
late 1994, US domestic spending would decelerate in 1995. In the months leading up to the July 1990 start of the previous
economic recession, the 10-year Treasury yield actually climbed above the 30-year Treasury yield. Nonetheless, some argue that
the predictive power of this yield spread has dwindled along with the smaller supply of 30-year Treasury bonds relative to 10-year
Treasury notes.
Higher Rates May Help To Correct Overvaluation Of Equity Shares
A more realistic appraisal of equity share prices can only enhance the relative appeal of those dowdy bonds. It was recently
reported in Baron's that the price-to-earnings ratio of the NASDAQ composite stock price index may have reached a gravity-defying
200-to-1 by year-end 1998. Wow, that's like the yield spread over Treasuries for high-yield bonds dropping to 50 basis points!
Further, many once judged Japan's equity market to be grossly overvalued at a price-to-earnings ratio of 70-to-1. Even year-end
1998's price-to-earnings ratio of the not-so-technology-heavy S&P 500 was a comparatively stratospheric 44-to-1.
To the extent equities are perceived as being richly valued, a stock market sell off will buoy the price of fixed-income securities,
which are less likely to stray as far from underlying value. A moderation of inflation expectations is not required for lower bond yields
if investors flee equities for the relative safety of quality bonds.
Amid considerable equity market volatility, the yield spreads over Treasuries of high-yield bonds have been well behaved, rising by
no more than 10 basis points since late 1999. Moreover, the yield spread over Treasuries for long-term, investment-grade industrial
company bonds was recently at 129 basis points, which not only trailed December 1999's 135 point average, but outshone all of its
previous monthly averages going back to the 117 points of August 1998. Also, 10-year swap spreads were recently at 77 basis
points, which was down from September 1999's average of 98 points.
The yield spreads of both investment- and speculative-grade corporate bonds ended 1999 drifting lower. Rightly or wrongly, the
credit market has not become increasingly concerned about any broad based softening of debt repayment capabilities.
Will Stronger Profits Stoke Wage Inflation?
December's 315,000 new jobs, 0.4% monthly increase by the average wage, and unchanged average workweek added up to a
prospective 0.7% monthly increase for wage and salary income. Nevertheless, the year-over-year increase of wages and salaries
has slowed from its 7.9% peak of 1998's third quarter to the 6.5% of 1999's fourth quarter.
In a tight market, demand gains enough on supply to put upward pressure on prices. Despite evidence of a dwindling pool of
available workers -- fewer unemployed individuals and a decline in the number of those not in the labor force but willing to take a job
given the right opportunity -- the annual rate of wage growth has sagged from second-quarter 1998's 4.3% to the 3.7% of 1999's
fourth quarter.
The labor market has not yet tightened by enough to escalate wages. December's unexpectedly steep 0.4% monthly increase by
average hourly earnings does not promise more of the same in the future. However, if profitability continues to improve, the demand
for labor ought to further outrun supply and put more upward pressure on wages. Were the unemployment rate to break under 4%,
the annual rate of wage growth could rise above fourth-quarter 1999's 3.7%.
New evidence of a tighter labor market took the form of a renewed decline by the pool of available workers to 9.3 million in
December -- the category's lowest reading yet for the current business cycle upturn. Also, December's quit rate of 14.5% topped
both its 1999 average of 13.4% and all annual averages going back to 1990's 14.7%. The quit rate's annual average most recently
bottomed at 1994's 9.9%.
In 1999's final quarter, the number of announced job cuts fell by 52% year-over-year, which was all but diametrically opposed to
first-quarter 1999's 51% year-to-year jump in the number of publicized job cuts. Fewer mass layoffs could help to tighten the labor
market and, thereby, put more upward pressure on wages. The decline in scheduled firings could be ascribed to the improved
performance of corporate earnings, which may have much to say about how inflationary wage growth becomes.
When asking why wages haven't responded more forcefully to a declining unemployment rate, the slower rise of profits needs to be
considered. During the six years ended 1997, the profits from current production of US nonfinancial corporations expanded by an
invigorating 14.4% per year, on average. Subsequently, the annual increase of profits from current production sagged to 1998's 2.2%
and to the 1.8% of the year-ended September 1999.
Although wage growth may have been slowed by the pronounced deceleration of corporate earnings, the market value of
nonfinancial corporate equities continued to rise briskly. After advancing by 16.6% per year during the six years ended 1997, the
market value of nonfinancial corporate equities advanced by 22% annually in 1998 and expanded by 16.8% annually during the year
ended September 1999. Equity investors strongly sense that corporate earnings will quicken. If the profits expectations implicit to
stock market valuation prove to be correct, then an acceleration of wages is likely.
Does a Record Equity Rally Make Corporate Debt's Collateral Safer?
As of June 1999, the market value of nonfinancial corporate equity approximated a record 311% of nonfinancial corporate debt
outstanding. The steep ascent by the ratio of the market value of equity to debt from 1990's low of 120% to a recent 300% helps to
explain the rise in the annual growth rate of nonfinancial-corporate debt outstanding from year-end 1994's 5.7% to September 1999's
12.3%.
The rapid increase by the market value of equity might be abetting an acceleration of corporate debt that could eventually damage
credit worth. Oddly enough, when nonfinancial corporate debt surged higher by roughly 12% annualized during the six years ended
1989, the market value of equity shares approximated only 122% of outstanding corporate debt, on average.
Does the comparatively steep valuation of equity shares relative to debt imply the same for the liquidation value of the assets
supporting corporate debt. During the 1980s, many were chided for not emphasizing market value over book value when comparing
a company's equity and debt positions. However, that controversy would generally be decided in favor of the traditionalists following
the corporate debt repayment troubles of 1989-1991.
NAPM Index Hints Of Tighter Job Market And Inflation Risks
December's manufacturing activity index from the National Association of Purchasing Management (NAPM) reflected a brisk pace of
industrial activity and reinforced notions of rising inflation risks. After having most recently peaked at September 1999's 57.8, the
NAPM's manufacturing activity index has dipped for three straight months to December 1999's still exemplary 55.5.
The NAPM's manufacturing activity index tends to be well correlated with Treasury bond yields. In 1998's final quarter, both the
NAPM's major index and the 10-year Treasury yield bottomed at 46.9 and 4.7%, respectively. By the final quarter of 1999, the
NAPM index and the 10-year Treasury yield had climbed up to their respective averages of 56.1 and 6.1%. At last look, the 10-year
Treasury yield was at 6.54%. The 10-year Treasury yield was last this high in June 1997 -- or just prior to the start of Asia's financial
and economic crisis without which US bond yields would have never dropped to their 30-year lows of late 1998.
Also around June 1997, the NAPM's index of manufacturing activity was well on its way at rising from its first quarter 1996 low of
46.2 to its third quarter 1997 high of 56.0. The 10-year Treasury yield would climb up from the 5.7% of the quarter-ended February
1996 to the 6.8% of the quarter ended May 1997.
If analysts believe that gains in the NAPM index are quite vulnerable to a reversal, bond yields can decline even if this important
indicator of US economic activity moves higher. Bond yields started to fall well before the NAPM index peaked in 1997's third
quarter because investors well anticipated the economic drag stemming from the then unfolding Asian economic slump.
Moreover, investors sensed that US production schedules were becoming too ambitious in view of how the annual growth rate of US
business sales dipped from the 5.9% of 1997's first quarter to the 5.5% of 1997's third quarter, while the annual increase of
inventories rose from 2.5% to 4.1%.
Among the December NAPM index's components, the most noteworthy performance was belonged to the employment index's
54.3-point reading, which was the steepest such score since December 1988's 54.8, or when nonfarm payrolls expanded by
323,000. For 1999's final quarter, the NAPM's employment index averaged 53.1, which topped all prior three-month averages going
back to the 53.3 of the quarter-ended January 1989, or when nonfarm payrolls grew by 301,000 new jobs per month, on average.
As derived from a sample beginning with 1984's first quarter, fourth-quarter 1999's NAPM employment index has been associated
with the creation of 285,000 new jobs per month, on average. Not that far off, nonfarm payrolls grew by 274,000 per month, on
average, during the final quarter of 1999.
Another steep reading for the NAPM price index also caught the market's attention. Although down from October 1999's latest high
of 69.4, December's score of 65.7 for the NAPM's prices-paid index was up from both the 65.3 of November and the 31.1 of
December 1998.
The NAPM price index last rose up to something akin to its fourth-quarter 1999 average during 1994's second quarter. Bond yields
would not peak until the NAPM price index averaged 85.2 during 1994's final quarter, wherein the 10- and 30-year Treasury yields
crested at 8.05% and 8.17%, respectively.
Sharply higher industrial metals prices amid comparatively low rates of global industrial capacity utilization and the considerable
upside potential for expenditures growth outside the US preserves the possibility of an even higher NAPM price index. Nevertheless,
Treasury bond yields are likely to peak in a range of 7% to 7.25%, as opposed to the 8% to 8.25% of November 1994.
Because of an ensuing loss of business activity to higher borrowing costs, almost all of the "pipeline" inflation implicit to late-1994's
very steep readings on the NAPM's price index was never transmitted to the final prices of consumer goods and services. After
dropping from December 1993's 3.2% to December 1994's 2.6%, the annual rate of core CPI inflation would rise no higher than the
3.1% of April-May 1995, before slipping to 3% by year-end 1995.
In conjunction with one of the strongest performances by housing activity ever, the housing market index of the National Association
of Home Builders (NAHB) has maintained a wide lead over the manufacturing activity index of the National Association of
Purchasing Management (NAPM) -- even as the latter has recovered sharply from the 46.9 of 1998's final quarter to the 56.1 of
1999's final quarter.
The NAHB's huge 29.4-point lead over fourth-quarter 1998's NAPM index correctly foretold of upturns for both the entire US
economy and US manufacturing. For each prolonged episode where the housing market index held a very wide lead over the
manufacturing activity index, both industrial activity and the overall economy would improve. Still, an extended climb by interest
rates could be quite damaging to the housing market index by the middle of 2000.
Mortgage Applications Tumble In December
In response to a steeper than one percentage point year-to-year jump by the FHLMC's 30-year mortgage yield, December's
estimated averages from weekly indices compiled by the Mortgage Bankers Association (MBA) plunged by 79% year-to-year for
mortgage refinancing applications and dipped by 2% yearly for mortgage applications from potential home buyers. Nevertheless, as
derived from reports supplied by three major home-building companies, December's new home orders grew by 9.8% year-to-year.
For all of 1999, applications for mortgage refinancings plummeted by 55% annually, but from the unprecedented heights established
by 1998's 230% year-over-year surge. Mortgage applications from potential home buyers rose by 4% annually in 1999, for a fifth
consecutive annual gain. However, 1999's percentage increase for home buyer mortgage applications was well under 1998's 29%,
as well as trailing the 17% average annual advance of the four years ended 1998.
A look at the behavior of home buyer mortgage applications for the last five years underscores just how accustomed the US
economy has become to a brisk pace of home sales. Once home sales finally bend under the weight of possibly even higher
mortgage yields, new paradigm explanations on the brilliant performance of the US economy will fall out of fashion. Wall Street often
confuses itself with Seventh Avenue.
After advancing by 8.6% year-over-year through the first three quarters of 1999, real residential investment spending is expected to
retreat by 1.6% annually in 2000. Real residential investment last fell in 1995, by 3.6% annually.
Fewer mortgage refinancings and a dip in housing activity might help to slow the now blistering pace of consumer spending to the
still lively expansion of disposable personal income. Preliminary estimates for 1999 have the 5.2% annual advance of real consumer
spending charging past the 4% increase of real disposable personal income. For 2000, consumer spending could slow to 3.5%,
while disposable personal income dips to 3.8%.
The better than expected December sales of GM capped a record-breaking year for unit sales of cars and light trucks in the US.
About 17 million new cars and light trucks were sold in 1999 -- up by 9% from 1998's 15.6 million. Most look for light motor vehicle
sales to drop under 16.7-million units in 2000.
December unit sales of US-built cars and light trucks were up by 2% year-to-year, leaving this category's annual increase for 1999
at 7%. Helping to promote world economic recovery, US imports of light motor vehicles surged higher by more than 21% annually in
1999.
Quarterly New Home Sales: First Yearly Drop Since 1995
As interest-sensitive activity subsides, bond yields are more likely to have formed a peak. Thus, November's 7.1% monthly drop by
new home sales was welcome news to a battered bond market. Compared to November 1998, new home sales sank by 12.2%.
However, maybe a shortage of supply -- as opposed to a lack of demand -- was what trimmed November home sales. A sharper
climb by prices amid fewer sales can often be ascribed to a reduction in supply. In November, the median price of a newly sold
home was up by 10.9% year-to-year, while the average price of a new home soared by an even steeper 17.4%.
For the quarter-ended November, new home sales prices were up by 5.6% annually at the median and higher by 11.2%, on average.
At the same time, however, new home sales fell by 3.6% year-over-year. The annual increase of new home sales most recently
peaked at the 15.4% of 1998's final quarter.
New home sales' three-month moving average last declined yearly (off by 10.3%) during the quarter-ended May 1995. Also, the
three-month average of new home sales last entered into as deep of a year-to-year setback during 1994's final quarter, which also
coincided with an important peak for bond yields.
LLCBrisk Sales At Home And Abroad Drive New Orders Higher
A livelier pace of spending both at home and abroad has supplied new factory orders with a lift. For "impact" durable goods
bookings -- or new durable goods orders having a more immediate impact on manufacturing activity -- their average monthly
increase rose from the 0.2% of 1999's first half to the second-half's 0.7%.
In an intriguing manner, the year-over-year increase of "impact" durable goods orders has steadily dipped from its latest 10.1% peak
of the span ended August 1999 to the 7% of the span-ended November. Previous peaks for the annual increase of three-month
"impact" durable goods orders were formed at the 9.2% of the span ended October 1997 and at the 16.1% of the span ended
August 1994. Unless impact durable goods orders re-accelerate, a peak for bond yields may be nearby.
Arguably, safe passage into 2000 might unleash a new wave of orders from those companies that approached the millennium with
caution. Strong consumer spending may have depleted inventories by enough to soon force new bookings higher. November's
monthly increases showed a healthy distance between the 1.2% advance by manufacturing shipments and the 0.5% gain of factory
inventories. It's hard to slow orders when sales outrun inventories.
Among manufacturing's high-tech components, the quarter-ended November 1999 revealed year-to-year increases by new orders of
8% for office and computing equipment, of 35.6% for communications equipment, and of 13.9% for electronics components (mostly
semiconductors). For 1999-to-date, new orders grew by 8% annually for computer and office equipment, advanced by 21.5%
annually for communications equipment, and increased by 17.1% annually for electronics components.
Hinting of an increase in the demand for labor if new orders growth is revitalized was November's 10.2% yearly jump by unfilled
backlogs of "impact" durable goods orders.
Office Construction Falls Way Short Of Its 1984-1989 Pace
Perhaps, nothing is more overvalued in the US economy than the share prices of internet and high technology companies. You are
probably off the mark if you believe that a possible overvaluation of commercial real estate poses a grave threat to the longevity of
this extended business cycle upturn. The credit cycle may have peaked for commercial real estate, but a replay of the debacle of
the late-1980s and early-1990s seems unlikely.
Up by 14% for the quarter-ended November 1999, construction spending on office space should gain 11% annually for all of 1999,
after advancing by 17% in 1998 and surging by 19% in 1997. However, these recent advances must be viewed in a broader context.
Construction spending on offices has shrunk relative to the overall economy. During the eight years ended 1993, construction
outlays on office space sank by 11% per year, on average. Reflecting that long-lived contraction, 1999's prospective $37.3 billion of
spending on office buildings falls considerably short of 1984-1989's annual average of $45.4 billion, never mind 1985's $53.5 billion
zenith.
Inflation Rose And Fell With Government's Share Of Total Jobs
Perhaps more than coincidence explains why inflation's rise and fall has coincided with the ascent and decline of government jobs
relative to total employment. Amid ample budgets and considerable upward scope for tax revenue growth, at one time, governments
may have faced little in terms of market discipline when hiring and compensating their employees. Such flexibility has long since
disappeared. In turn, fewer private-sector employees can bargain for a higher wage using the threat of quitting their current job for
one in the public sector.
Governments supplied 15.6% of nonfarm payroll jobs in November -- the lowest such share since November 1960 or the final months
of the Eisenhower administration. Government employment would eventually peak at 19.2% of nonfarm jobs in April-July 1975.
Government employment averaged 16.5% of nonfarm payrolls in the 1990s -- the same share as that of the 1960s, but up from the
13.9% of the 1950s. In the 1970s -- a most inflationary decade -- government jobs averaged 18.2% of total employment and would
then drop to 17.1% of total employment in the 1980s.
Eurozone PMI Posts A New Record High
The Eurozone's Purchasing Managers Index (PMI) rose from November's 57 to a record 57.4 in December 1999. Favoring faster
European economic growth would be how the Eurozone PMI's December reading was well above its 51.7-point average of the 12
previous months.
Inflation risks may be on the rise globally. The Eurozone PMI's prices-paid component was a steep 66.0 -- far above its 50.8 average
of the 12 previous months.
Moody's industrial metals price index advanced by 33.8% from the beginning to the end of 1999 for its steepest such advance since
1994's 42.6%. The industrial metals price index had rebounded from 1998's 16.7% slump, which marked the end of a 28% four-year
long cumulative slide.
Look For Faster European Household Expenditures
Ordinarily, declining unemployment is constructive for household expenditures. Declining unemployment in the European Union
(EU) should enliven European consumer spending. Nothing boosts confidence and the willingness to spend like the perception of a
firmer labor market.
Germany's seasonally-adjusted number of unemployed individuals fell by a comparatively deep 68,000 from November to December.
Germany's not-seasonally-adjusted unemployment rate for December was 10.3% -- down from the 10.9% of December 1998 and
the lowest jobless rate for any December since the 9.9% of 1995. In December 1999, jobless Germans were 3.6% fewer
year-to-year. In a constructive manner, year-to-year changes for 1999's fourth-quarter showed the number of Germans assigned to a
shortened workweek declining by 13%, while the number of unfilled job vacancies grew by 21.9%.
The unemployment rate of the entire 15-country European Union, or EU-15, fell from November 1998's 9.7% to 9% in November. The
EU-15's jobless rate has not been this low since averaging 8.7% in 1991.
US wage growth and price inflation has been restrained for the longest period of time by Europe's persistently slack labor market.
The EU-15's unemployment rate peaked at the 11.3% of February-March 1994, or just about when rapid US expenditures growth
last set off an inflation scare that drove US bond yields sharply higher.
Perhaps, the undervalued euro exchange will supply the Continental economies with an important boost in 2000. German industrial
orders have been on a tear, rising by 1.2% monthly in November following October's 3.3% advance. For October-November 1999,
German industrial orders climbed higher by 10% yearly, wherein domestic orders climbed higher by 6.5%, while foreign orders
advanced by 15.5%.
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John G. Lonski, chief economist |
