Investors Prepare For Several More Rate Hikes
John Lonski, Moody's senior economist in New York
More rate hikes loom. The latest decline by Treasury yields will be more than reversed by forthcoming inflationary pressures
emanating from the continuation of brisk domestic spending and the quickening of expenditures abroad.
Lower borrowing costs ought to extend the ongoing boom in household expenditures. For January, total unit sales of cars and light
trucks rose by 10.1% annually, while the same store sales of 75 retailing chains grew by 5.5% annually.
Further, initial state unemployment claims apparently fell for a fourth consecutive month in January. The continuation of labor market
tightening increases inflation risks.
The latest upturn by factory orders and the lengthening of unfilled backlogs for "impact" durable goods bookings hints of a steeper
rate of industrial capacity utilization that could intensify the inflation threat following from the lowest jobless rate in nearly 30 years.
Declining joblessness ought to spur consumer spending. The prices of internationally-traded consumer goods are likely to firm if
household spending grows briskly in both Europe and the US.
The release of pent-up demand is a very real possibility for European consumer expenditures. For all 15 member countries of the
European Union (EU-15), December 1999's 8.8% unemployment rate was under November's 9%, as well as the 9.6% of December
1998. December's jobless rate was beneath all previous annual averages going back to 1991's 8.7%.
In response to rising inflation risks stemming from both a livelier European economy and an even weaker euro exchange rate, the
European Central Bank lifted its base lending rate from 3% to 3.25%, just a day after the February 2nd hiking of the US' federal
funds rate from 5.5% to 5.75%.
Despite central bank tightenings and signs of global economic vigor, the latest February-to-date results showed the 10-year US
Treasury yield declining by 11 basis points to 6.55%, and the 10-year German government bond yield slipping by five points to
5.49%.
Because the evidence favors a forthcoming climb by rates of resource utilization worldwide, the likelihood of even greater inflation
risks implies that interest rates have yet to peak. Investors should be prepared for a 6.25% federal funds rate by the end of June and
for an eventual run by the 10-year Treasury yield above 7%. Barring either a marked slowing of US expenditures or severe financial
difficulties overseas, another 25 basis points hiking of the federal funds rate on March 21st is practically assured.
Demand For Labor Gains On Its Supply
New evidence of labor market tightening was supplied by January's unexpectedly large 387,000-worker addition to nonfarm payrolls.
Moreover, January's seasonally-adjusted pool of available workers -- the officially unemployed plus those not looking for work but
willing to accept a sufficiently attractive job offer -- fell by 2.1% from December 1999 and was off by 7% yearly. A relative scarcity of
labor could also be inferred from January's 4% unemployment rate -- the lowest in 30 years.
Combining January's 0.3% monthly expansion of nonfarm payrolls with a 0.4% rise by average hourly earnings plus the 0.3%
lengthening of the average workweek favors a sizable 0.9% monthly advance for wage and salary income. In a puzzling manner
given the presence of labor market tightening, the annual increase of wage and salary income sagged from its latest 7.9% peak of
1998's third quarter to fourth-quarter 1999's 6.5%. The jobs report signaled a possible 6.8% annual increase for wages and salaries
in January.
The faster growth of employee compensation can boost inflation risks by increasing both labor costs and household expenditures.
Higher wages make it costlier for businesses to boost production in response to the growth of demand, where the latter will be
stoked by earned income's faster rise. Price growth can only steepen as expenditures quicken relative to the expansion of
production capacity.
After having last peaked at the 4.4% of April 1998, the annual increase of the hourly wage has since descended to January 2000's
3.5%. Late 1998's pronounced slowing of profits in response to the abrupt deceleration of world economic growth from 1997's 4.4%
annual advance to 1998's 2.6% helps to explain wage growth's recent slide. Although announced job reductions tailed off
considerably by year's end, they were up by 29% year-over-year through the first nine months of 1999.
About the time profits began to suffer from the global financial crisis, the US' nonfarm payrolls had been expanding by 273,000 new
jobs per month, on average, during the 12-months ended August 1998. Thereafter, the average monthly addition to nonfarm payrolls
would subside to the 224,000 of the 12-months ended September 1999.
A subsequent rebound in profitability following from the recovery by world GDP growth to 1999's 3.1% gain helps to explain why the
average monthly increase of nonfarm payrolls has since increased to the 311,000 of the four-months ended January 2000. If as
expected, the world economy grows more rapidly in 2000, a consequent upturn by business net income should spur hiring activity.
Increasing the demand for labor amid an already tight labor market will probably accelerate wages and salaries. Until labor market
utilization peaks, the faster growth of employee compensation may augment inflation risks and, thereby, lead interest rates higher.
Changes in the demand for labor can be approximated by changes in the number of hours worked. The year-to-year increase by the
employment report's index measuring the number of hours worked in the private sector declined from its 3.9% peak of 1997's first
quarter to the 1.8% of 1999's second quarter.
January's index of hours-worked jumped up by 0.6% monthly for its steepest such advance since September 1998. If the index of
labor hours remains unchanged in February and in March, first-quarter 2000's hours of work should expand by 3% annualized from
the prior quarter, while increasing by 2.2% yearly. For 1999, the quarter-to-quarter annualized gain for hours of work averaged 2%,
nearly matching its year-long annual increase of 1.9%. Inflation worries can only mount if the demand for labor re-accelerates at the
lowest jobless rate in 30 years.
A diffusion index which estimates the breadth of hiring activity by subtracting the percentage of industries cutting staff from the
percentage adding workers has been rising anew. After most recently cresting at the 63.7 of 1997's final quarter, the employment
diffusion index would then descend to its 54.1-point bottom of the quarter-ended October 1999. Reinforcing the notion of a
potentially inflationary rejuvenation of hiring activity has been the employment diffusion index's subsequent rise to its 57.2-point
mean of the quarter-ended January 2000.
Higher Interest Rates Have Yet To End Consumer Spending's Boom
Suggesting that higher borrowing costs have yet to significantly curbed domestic expenditures, January's average index of mortgage
applications from potential home buyers rose by an estimated 4.2% from December 1999 while growing by 4% year-to-year. The
latter disagrees with consensus forecasts of an 7% annual decline by housing starts in 2000.
However, while the Mortgage Bankers Association's (MBA) index of applications for mortgage refinancings was up by 6% monthly in
December, it still plummeted by 76% yearly. Fewer mortgage refinancings warn that consumer expenditures will not well outpace
personal income indefinitely.
With reference to the previous bond yield upsurge of 1994, the index of mortgage applications for the purchase of a home was down
by 16% annually when yields peaked in November of that year. Moreover, home buyer mortgage applications had contracted by
17% annualized from the first to the second half of 1994. By contrast, not only was January 2000's home buyer mortgage
applications index up by 4% yearly, but this indicator of housing demand was unchanged, on average, comparing the six-months
ended January 2000 with the six-months ended July 1999.
The FHLMC's 30-year mortgage yield averaged 8.26% in January, which was up by 147 basis points from a year earlier. Absent
either a slackening of the labor market or an equity market rout, the 30-year mortgage yield may need to reach 8.75% if home sales
are to slow by enough to lessen the inflation risks stemming from housing's overall impact on expenditures.
Nonetheless, the latest findings on new home sales revealed a loss of momentum. As the drop in mortgage refinancings have
already shown, higher mortgage yields have not been without effect.
Although December 1999's new home sales jumped up by 4.5% from the prior month, they were off by 6.1% year-to-year. For
1999's final quarter, new home sales shrank by 3% annualized from the third quarter, while dropping by 5.8% annually.
Also, during 1999's final quarter, the residential investment component of real GDP dipped at a 1.2% annualized rate from the
previous quarter and rose by 3.1% yearly. In response to higher interest rates, real residential investment slowed considerably from
its 11.1% year-over-year increase of 1999's first quarter.
Does inflation start at home? The residential property price deflation of the early-1990's was followed by widespread consumer price
disinflation later in the decade.
Despite a loss of sales momentum, the price growth of new homes has accelerated. In the final quarter of 1999, not only was the
median sales price of a newly sold home up by 7% year-over-year, but the average sales price was up by an even steeper 12.4%. If
consumers have been able to shoulder higher prices for housing and for energy products, can a broader array of price advances be
far behind?
Lower Bond Yields Contradict Fed Efforts
No longer are Treasury bond yields moving in a direction that reinforces the intention of monetary policy. Accordingly, more of the
burden of slowing the US economy falls on Federal Reserve interest rate hikes.
Just when the Fed is attempting to slow the US economy through a tighter monetary policy, expectations of an extended reduction
in the supply of US Treasuries have also pared the private sector's fixed-rate borrowing costs.
Wider corporate bond yield spreads over Treasuries do not imply that corporate bond yields are rising. Rather, yield spreads have
widened because corporate bond yields have not descended by as much as Treasury yields. Thus far in February, our yield average
for long-term investment-grade industrial company bonds has dropped from 7.9% to 7.69%. As recently as January 19th, this yield
was at 7.99%.
Treasury Debt's Contraction Stokes Corporate Debt Growth
The recent widening of corporate bond yield spreads over Treasuries can largely be attributed to the simultaneous contraction of the
US Treasury's public debt obligations and the acceleration of corporate debt outstanding. During the 12 months ended September
1999, the $461 billion addition to US nonfinancial corporate debt differed drastically from the accompanying $87 billion decline in the
net debt of the US Treasury. Since 1983, the $177 billion average annual net borrowing of nonfinancial corporations was nearly
matched by the US Treasury's $167 billion average annual net borrowing.
Nevertheless, to the degree a drop in benchmark Treasury yields accelerates corporate debt growth, the debt repayment
capabilities of US companies could eventually suffer. All too often, an extraordinarily deep decline in interest rates has sparked a
steep upturn in private-sector borrowing which ultimately led to diminished debt repayment capabilities.
Record High For Confidence And A Record Low For Savings
Intuitively, consumer-spending prospects seem more attractive when disposable personal income outruns consumer expenditures.
Nevertheless, why has consumer confidence risen to record levels amid an unprecedented low for the personal savings rate?
Unmatched levels of consumer confidence cannot easily be reconciled with a fast rising debt service burden. If the repayment of
household debt were becoming far less manageable, consumer confidence would not have climbed to record highs. Moreover,
consumer loan delinquencies are still comparatively infrequent.
According to 1999's imbalance between 5.3% real consumer spending growth and 4% real disposable personal income growth, as
well as a very low 2.2% personal savings rate and rising interest rates, household expenditures are likely to slow in 2000. An
early-January 2000 consensus forecast had real consumer spending slowing from 1999's 5.3% to 3.8% in 2000, as unit sales of
motor vehicles sag from 1999's 7.2% advance to 2000's 3.5% contraction and housing starts switch from 1999's 3.2% gain to an
8% decline. Notwithstanding expectations of an even tighter labor market, the consensus projects a slowing or real disposable
personal income growth from 4% to 3.4% in 2000.
Consumer spending has received considerable support from an unparalleled stock market rally. The 25% average annual advance
by the market value of US equities during the five years ended 1999 allowed the price appreciation of the household sector's stocks
and mutual funds to approach 36% of wages and salaries. Prior to the great stock market rally of 1995-1999, the price appreciation
of household equities had risen to nothing higher than the 19% of wage and salary income for the five years ended 1968.
Savings Rate Peaked In 1982
In 1999's final quarter, the US' personal savings rate averaged 1.9%. The personal savings rate has been on a declining trend for
some time. The declining personal savings rate reflects little more than the faster growth of consumer spending relative to
disposable personal income.
During the 1960s and 1970s, real disposable personal income's 4.1% average annual increase edged out the 4% average annual
increase of real consumer spending. In turn, the personal savings rate would climb up from the 7.2% of 1960 to the 10.9% of 1982.
Over the 20-years ended 1999, the 2.9% average annualized increase of real disposable personal income lagged the accompanying
3.2% average yearly gain of real consumer spending. In turn, the personal savings rate would ultimately fall to 1999's 2.4%.
Latest 5 Year Showing By Consumer Spending Lags 1983-1987 Spree
During the five years-ended 1999, the market value of US common equity shares climbed higher by 25% per year, on average. An
unprecedented five-year surge by stock prices allowed the 4% average annual advance by real consumer spending to outrun real
disposable personal income's corresponding 3.4% average annual gain.
Household expenditures also received an extraordinary boost from a major decline by borrowing costs. Not only did the average
30-year mortgage yield drop from the 8.7% of the five years ended 1994 to the 7.55% of the five years ended 1999, but the price
performance of housing also improved significantly. Who can forget the residential property price deflation that struck hard at the
Boston-Washington corridor and at Southern California during the early 1990s?
The much heralded stock market rally of the 1960s looks tame compared to the great surge of the 1990s. Better yet, the average
annualized advance of the S&P 500 stock price index was 14% during the 1950s which was well above its 4% average yearly rise of
the 1960s In fact, no five year span of the 1960s came close to matching the 20% average annualized advance of the S&P 500 for
the five years ended July 1955. In terms of stock price appreciation, the 1950s were much more analogous to the 1990s than were
the 1960s.
Across five-year spans, real consumer spending's average annualized growth rate most recently peaked at the 4.7% of 1983-1987,
or when real disposable personal income averaged a 3.9% yearly gain while the market value of US common stocks would post a
scintillating 23% average annual surge during the five years ended July 1987. Real disposable personal income's 4.2% average
annual advance of the five-years ended 1988 remains the fastest for any five-year span since the 4.6% of 1969-1973.
The stock price collapse of late 1987 lowered the 5-year average annualized increase of US stock market valuation to 11% by
December 1987. The equity market correction of late 1987 would lead to an important re-evaluation of real estate prices that would
bring an end to the real estate boom of the 1970s and 1980s.
Real consumer spending's 5-year average annual growth rate peaked at the 5.4% of 1964-1966. The lagging 5-year average annual
increase of the S&P 500 stock price index would slide from the 12% of the span ended October 1965 to the 2% of the span ended
December 1966. Powering the growth of household expenditures during 1962-1966 was an extremely robust 5.5% average yearly
advance by real disposable personal income. The performance by real disposable personal income during 1963-1966 and 1964-1966
(also up by 5.5% annually) has been unrivalled ever since.
Energy's Share Of Consumer Spending Drops Sharply
Energy outlays enter into consumer spending under both the nondurable goods and the services categories. In 1999's'final quarter,
consumer energy outlays were up by 15% year-over-year in current dollars for the steepest such increase since the 15.7% advance
of 1980's final quarter. For all of 1999, consumer energy expenditures grew by 5.6% annually. However, 1998's retreat left energy
outlays dipping by 0.6% per year, on average, during 1998-1999.
When household energy spending surged by 18.7% annualized during 1973-1974 and by 23.5% annualized in 1979-1980,
recessions would soon follow from energy's much bigger grab of spendable income. Since the early 1980s, the liveliest two-year
advance by consumer spending on energy products was the 6.3% average annual increase of 1989-1990, which also led to an
economic downturn.
Because of the more efficient use of energy and because of lower prices, the latest upswing by energy prices is less of a threat to
consumer spending than a proportional rise would have been during previous decades. The real personal consumption of energy
slowed from the 2.5% average annual increase of the 1970s to the 1.1% of the 1980s and the 1.2% of the 1990s.
Energy outlays sank to a record low 4.1% of personal consumption expenditures during the 6-months ended March 1999, rising to
just 4.4% of consumer spending by 1999's final quarter. Energy outlays peaked at 9.2% of consumer spending in 1981. Higher
energy prices constituted a greater threat to household expenditures when energy outlays averaged 7.4% of consumer spending in
the 1980s and 7.1% during the 1970s.
Corporate Performance Can Direction To Treasury Yields
Ultimately, Treasury yields take direction from the performance of business sales. Faster price growth may be unavoidable if bond
yields decline amid brisk business sales. A peaking of the annual growth rate of the four-quarter moving average of business
operating income in 1984 and in 1987 was accompanied by a cresting of the 30-year Treasury yield.
Moreover, bond yields can be expected to rise when corporate earnings accelerate, especially when improved profitability
encourages business expansion at already high rates of resource utilization. As US corporate earnings now quicken in response to
a livelier global economy, the rate of industrial capacity utilization can be expected to rise, which would add to inflation worries. In
addition to an already strong labor market, a higher rate of industrial capacity utilization might soon put upward pressure on interest
rates.
Alternatively, the failure of bond yields to decline as a deceleration of business sales lengthens can greatly increase the danger of
an economic downturn.
The more bond yields decline when profitability sags, the better stock prices will withstand a broadly-distributed earnings slowdown.
Lower borrowing costs can shorten the expected duration of a profits slump.
The global economic slump of 1998 helped to pare the annual growth rate of total business sales to the perilously low 2.5% of
1998's third quarter. Just prior to the start of the Asian financial crisis, the 10-year Treasury yield averaged 6.7% during 1997's
second quarter. A subsequent ebbing of business sales growth would lessen inflation risks and endanger US economic prospects
by enough to drive the 10-year Treasury yield down to its 4.67% average of 1998's final quarter. Thereafter, the 10-year Treasury
yield has climbed as high as 6.7% in response to the ascent by business sales' annual growth rate to fourth-quarter 1999's 8.6%.
Bond Yields Greatly Influence Stock Market Valuation
For US nonfinancial corporations, the ratio of outstanding debt to the market value of their equity shares has dropped from a
second-quarter 1982 high of 101% to the latest available reading of 35%. For 1998-1999, corporate debt was at its lowest level ever
compared to the market value of nonfinancial-corporate equity.
Debt holders do get concerned when the valuation of equity drops, but do not necessarily feel more secure when stock prices rise.
By no means do higher prices for equity shares imply necessarily enhance a company's debt repayment capacity.
Over the last 40 years, the ratio of corporate debt to the market value of equity has been highly correlated with the 10-year Treasury
yield. When the 10-year Treasury yield averaged 4.5% during the five years ended 1967, corporate debt approximated 38% of the
market value of equity. As the 10-year Treasury yield soared up to its 12.4% average of the five years ended 1984, debt would reach
82% of equity's market value during the five years ended 1984. For the 10-years ended September 1999, the ratio of corporate debt
to the market value of equity dropped to 41% in response to a decline by the 10-year Treasury yield to a 6.1% average.
At work may be little more than the tendency of equity prices to rise as interest rates decline, and vice versa. The spectacular surge
by US stock prices of the last five years owes much to what has been a long-lived downward trend for bond yields. Equity prices will
no longer advance by 25% per year if investors sense that bond yields have established a major bottom.
Exports Boost European Industrial Activity
The global competitiveness of the 11 member countries of the Eurozone has been enhanced by the continued weakening of the euro
exchange rate, which was recently off by 14.6% yearly in terms of the dollar.
The year-to-year growth rate of Eurozone exports climbed up from the 4.5% of the quarter-ended August 1999 to the 9.2% of the
quarter-ended November. Surprisingly, the weaker euro did not stop the Eurozone's comparably measured annual growth rate for
imports from advancing from 8.3% to 12.7%. The surge by imports in the face of a weaker currency suggests that domestic
spending in the Eurozone may be stronger than is commonly thought.
Export acceleration helps to explain why the estimated quarter-to-quarter annualized growth of EU-11 industrial production has
jumped up from the 1.2% of 1999's second quarter to the 4.5% of the quarter-ended November. For all 15 member countries of the
European Union (EU-15), the quarter-to-quarter annualized growth rate of industrial output quickened from the estimated 1.6% of
1999's second quarter to the 4.9% of the three-months ended November.
Japan's Unemployment Rate Rises Anew
Japan's economy still gropes for sound footing. After declining from June-July 1999's record high of 4.9% to November's 4.5%,
Japan's unemployment rate inched up to December's 4.6%. In 1999's final quarter, Japanese employment was off by 0.2% yearly,
which was shallower than the 1.3% annual decline of 1999's second quarter. Also, December 1999's 5.5% annual increase by the
number of jobless Japanese was less jarring than the 28.6% annual surge from that tumultuous month of August 1998
.
Services are on the rise in Japan's economy. . Fourth-quarter 1999 data revealed that Japanese employment in construction and
manufacturing fell by 1.3% yearly, while all other types of employment grew by 1% yearly.
Japan's labor market remains burdened by an abundance of job seekers compared to available openings. After bottoming at the
record low 0.46:1 of May-August 1999, the ratio of job offers per job seeker has barely risen to the still weak 0.49:1 of
November-December. Not since 1992's ratio of 1.08:1 have the number of job offers at least matched the number of job seekers. As
long as job offers significantly lag job seekers, Japan's economy may be hobbled by a lack of consumer confidence.
For all of 1999, Korean exports more than recovered from 1998's 2.8% decline and grew by 9% annually, while imports partly
recovered from 1998's 35.5% collapse with a 28.3% increase. For the quarter-ended January 2000, Korean exports advanced by
25.5% annually, as imports shot up by 44%.
How quirky exchange rates can be. Not only does Japan's economy struggle to regain respectability -- real GDP growth may fall
short of 1.5% in 2000 -- but the country's government budget deficit also soars relative to GDP. By contrast, European economic
growth should break above 3% in 2000, while the region's government budget deficits generally decline relative to GDP.
Notwithstanding considerable evidence to the contrary, the Japanese yen was recently up by an incredibly steep 26.8%
year-to-year in terms of the euro. Alternatively, the euro has sunk by 21.2% annually in terms of yen.
John Lonski, chief economist |
