Interesting take on this week's bond weakness --
Nomura Economics Briefing Packet > 06/08/2007
Raised Expectations—Self-Fulfilling or Self-Deflating
For most of the past six to twelve months, fears that the U.S. housing contraction could pull the overall economy into a recession or a long stretch of stagnation have helped keep U.S. interest rates below levels that one would associate with sustainable economic growth. Now a string of better than expected U.S. economic indicators appears to have convinced bond market participants across the globe that the danger of an economic downturn has passed. Judging that the data indicate the U.S. economy will resume growth at its underlying potential much sooner than expected, the global financial markets have driven long-term interest rates
up sharply. While recent news reports of strong overseas growth and increasing strains on global capacity have identified a growing worldwide inflation threat, the surge in interest rates in the U.S. and elsewhere in the past two months has not been accompanied by shifts in inflation expectations. By Thursday’s close, for instance, the yield on 10-year “constant-maturity” Treasury notes was 47 basis points higher than on the final day of the second quarter (March 30). Over the same span, the yield on the 10-year TIPS had risen by 49 basis points. The increases in nominal and inflation-indexed U.S. interest rates mirrors the pattern of rate increases in other major markets and suggests that realignment of global interest rates reflects an upgrading of expectations of global economic growth.
Recent economic data have indeed warranted a marking up of near-term real GDP growth for the U.S., but the inference that the “growth recession” has ended seems premature. The June Blue Chip Economic Indicators (BCEI) consensus forecasts 2.8% growth in the second quarter, an increase of 0.4% from a month earlier. However, a bigger upswing in inventory investment accounts for much of the faster than expected second quarter growth as the consensus forecast for consumer spending fell slightly from 2.2% in May to 2.1% in June. Another decline in vehicle sales in May and lackluster sales by core retail establishments could necessitate further down-grading of the consumer spending outlook. Moreover, the BCEI consensus forecasts for the second half of 2007 did not change, so the upgrading of Q2 growth does not seem to reflect a fundamental shift in the outlook.
Absent such a shift, the rise in real interest rates in the U.S. imposes an added restraint on domestic demand. Moreover, higher rates could prolong and deepen the housing downturn and increase the risk of a serious fall-out associated with adjustable rate mortgage resets. Continuing softness in domestic demand would also dampen demand for imports and undermine a key support for strong growth overseas. Though likely to be merely transitory “noise,” the weakness in both imports and capital goods exports in April could become typical if domestic U.S. demand remains weak much longer. From this perspective, the markets seem a bit premature in concluding that the U.S. economy has passed the danger point and that healthy growth is now assured.
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