Credit Market Overview -- New York, October 4, 1999
Treasury Bond Yields Should Climb Higher
John Lonski, Moody's senior economist in New York
Bond yields moved sharply in response to September's much-stronger-than-anticipated manufacturing
activity index of the National Association of Purchasing Management (NAPM). Many credit market
participants now realize that they probably badly misinterpreted the Federal Open Market Committee's
(FOMC) statement following its meeting of August 24th. By no means is the Federal Reserve finished
with tightening monetary policy for 1999. If the FOMC does not vote to hike federal funds on October
5th then the action will probably occur on November 16th.
Factories should hum loudly into the new year according to the NAPM's new orders index for
September, which, at 64.4, was a tall 10.8-points above its lagging 12-month average. The NAPM's
production index was also at a very steep 61.7 in September. Industrial production's latest acceleration is
far from over. Higher bond yields will test the strength of those fundamentals supporting richly-price
equity shares.
The more rapidly expenditures grow relative to production, the higher will be the rate of price inflation.
Suggesting that the production and distribution of merchandise may be falling behind sales growth were
the advances posted by the NAPM's indices describing orders' backlogs and delivery waiting times.
Faster export growth awaits the US economy according to the second straight monthly rise by the
NAPM's export orders index from August's already expansionary 54.2 to September's livelier score of
56.6. Not since the 57.3 of March 1997 has the export orders index shown so much vigor.
The NAPM's export orders index averaged 53.7 in the third quarter -- up from the second quarter's 52.4.
The export orders index previously experienced comparable upswings during the second-half of 1993 and
the first-half of 1996. With reference to the 1993 incident, the annual growth rate of exports would climb
up from the 1% of 1993's third quarter and not crest until reaching the 16.1% of 1995's first quarter.
Regarding 1996's experience, after momentarily slowing from a 7.4% yearly increase in 1996's second
quarter to a 3.1% rise in the third, the annual increase of exports would then steadily climb up to its most
recent high of 14% for 1997's third quarter.
Almost always, the US' export performance depends on the pace of foreign economic activity. Thus, the
latest upturn by the export orders index reflects a faster rate of economic expansion outside the US.
Europe could attain surprising vigor in 2000. Off by 0.3% year-to-year for the quarter-ended July 1999,
the yearly increase of US merchandise exports to Western Europe might return to its 9.5% annual
average of 1995-1997 within 18 months.
The Eurozone has its own purchasing managers index (PMI), which rose from August's 53.2 to 54.7 in
September. Industrial activity in the world's two largest economies now expands more rapidly. The
Eurozone PMI's component describing prices of purchased goods jumped up from August's 57.6 to
September's 63.2. Outside the Eurozone, the UK's PMI also moved higher, from August's 53.1 to
September's 53.9.
To the surprise of most Japan's unemployment rate fell from its 4.9% record high of June-July 1999 to
August's 4.7%. In terms of year-to-year changes, the growth rate of Japanese joblessness abruptly fell
from July's 18.1% to August's 7.7%, while the contraction of total Japanese employment improved from
the 1.2% of the quarter-ended July 1999 to August's 0.5%.
Nothing more than a stabilization of the labor market would firm Japanese consumer spending. Although
average real household expenditures fell by 1.1% yearly, the decline owed much to an odd drop in food
consumption. Whenever US consumer spending falls because of a decline in food consumption,
consumer spending ordinarily rebounds sharply in the ensuing observation.
Perhaps the Japanese were too busy buying homes to eat. Japan's housing starts advanced by 8.4%
year-to-year in August, leaving starts up by 5.9% annually for the quarter-ended August. In terms of
annual growth rates, Japanese housing starts have now entered into their steepest ascent since early 1996.
For all of 1996, an 11.8% advance by housing starts contributed to a 5.2% annual climb by Japan's real
GDP. No wonder forecasters have been busy upwardly revising their estimates of Japanese economic
growth.
Housing was one of the few bright spots during the disappointing start of the US' now glorious economic
recovery. Similar to what eventually transpired in the US, an upturn by home sales should eventually lead
Japanese consumer spending higher.
Japan's industrial production for August grew by a sizable 4.6% from July, while climbing higher by 5.5%
yearly. Auguring well for Japanese manufacturing activity was August's healthy imbalance between an
8.7% yearly drop by inventories and a 5.8% yearly increase by factory shipments. August's 11.2%
year-to-year decline by Japan's inventory-to-sales ratio lends support to forecasts of an improved
Japanese economy.
Following a 7% average annual advance during the 5 years ended 1996, Korea's real economy would
slow to a 5% gain in 1997 before contracting by 5.8% in 1998. Indications are that Korean real GDP
growth for 1999 just might top 7%.
Korea's most forward-looking business survey index rose to its highest level since the final quarter of
1995. In 1995, the annual rate of Korean economic growth established its latest peak of 8.9%.
For August, Korea's industrial production was up by 29.9% year-to-year. The latest result was skewed
upwards by industrial production's 12.8% yearly drop of August 1998. Over the 2-years ended August
1999, Korean industrial output grew by 6.5% annualized, which is rapid enough to question the
hypothesis of a fundamental deceleration of East Asian economic activity. Boding well for near-term
Korean business activity was August's 14.2% annual contraction of inventories and the accompanying
17.7% yearly surge by retail/wholesale sales.
In the major economies of Korea, Japan, and the US, inventories have declined relative to sales. The
most pronounced synchronous upturn by the world's leading industrial economics since the late 1980s
may be emerging. Higher industrial commodity prices can be expected. Moreover, as world economic
growth turns higher, US Treasury yields should rise.
Inflation Risks Rise
Because of a livelier world economy, inflationary pressures are now rising with the ongoing
re-acceleration of US economic activity. The decline by the quarter-to-quarter annualized growth of real
GDP from the 4.3% of the first quarter to the 1.6% of the second bordered on being comedic as far as
revealing anything useful about the US' economy. Forget about headline GDP, the rise by the NAPM's
manufacturing activity index from the first-quarter's 52.1 to the 55.0 of the second-quarter was far more
successful at capturing the underlying vitality of the US economy.
The third-quarter's NAPM index average of 55.1 not only reflected a robust pace of industrial activity, its
sharp increase from its 49.1-point average of 1998's third quarter favored a steeper yearly rise for profits
from the second to the third quarter. As inferred from the climb by the annual increase of the NAPM
index from the second-quarter's 3.8- to the third-quarter's 6.1-points, the annual increase of nonbank
recurring profits should steepen from the second-quarter's 8.9% to 15% for the third quarter.
Investors were struck dumb by the NAPM's prices-paid index, which advanced from August's already
steep 59.8 to September's 67.6 -- a massive 24.6 points above its 43-point average of the 12 previous
months. The yearly advance of the prices-paid component jumped up from the second-quarter's 10.9
points to the 23.9 points of the third quarter. Not since the 24.8-point uprising of 1994's third-quarter has
the NAPM's price component climbed so steeply year-to-year.
In order to contain inflation risks in 1994, the federal funds rate would eventually be hoisted up to 6%,
while the 30-year Treasury yield would peak at the 8.07% of November 7, 1994. The latter was way
above its 5.94% average of October 1993. In comparison, a prospective 5.5% federal funds rate target
and a possible 6.5% 30-year Treasury yield look quaint.
Whether or not higher industrial commodity prices are the forerunners of higher prices for consumer
goods and services depends on the pace of global household expenditures. The available evidence favors
a global acceleration of consumer spending that should quicken consumer price growth.
By the time Moody's index of industrial metals prices was up by 45.5% yearly as of November 1994, the
inflationary warnings of breakneck industrial materials price inflation were already being diluted by a
diminution of household expenditures' momentum in both the US and Europe. The industrial metals price
index's monthly average for September 1999 was up by 16% annually, which was a far cry from its
20.4% yearly plummet of September 1998.
About the time US bond yields peaked during 1994's global economic acceleration, JP Morgan's global
government bond yield was up by nearly 200 basis points year-to-year as of November 11, 1994.
Recently, this benchmark indicator of fixed-rate borrowing costs rose by a much thinner 53 basis points
annually.
The pronounced sensitivity of US equity prices to the likelihood of higher interest rates underscores just
how grossly overvalued the US stock market might be. A possibly way over-priced stock market may be
the Treasury bond's best -- if not only -- friend.
Foreign Consumers May Begin To Mimic US Households
Rotation may be underway for the US economy. An extraordinarily robust pace of household
expenditures ought to slow, while foreign purchases of US output rise more quickly. However, the
deceleration of US household spending may not be severe enough to appreciably slacken the US
economy.
Consider how an export-led firming of profitability just might boost the demand for labor by enough to
prevent the annual growth rate of wage and salary income from falling under 6% and, by doing so,
preserve a relatively brisk pace of consumer spending.
Compared to an admirable 6.6% year-to-year climb by wage and salary income, retail sales grew by a
patently unsustainable 9.1% yearly for the quarter-ended August 1999. During the 5-years ended 1998,
the average annual rates of growth were much more closely aligned -- 5.7% for retail sales and 6.1% for
wage and salary income. Expectations of a 6.2% annual increase by wages and salaries for 2000 may
support a comparable rate of growth for retail sales, which would lag the latter category's 8.5% yearly
advance of January-August 1999.
Consumer spending should subside, but not collapse. By no means has household indebtedness reached
levels that threaten to slow consumer spending by enough to slacken the economy. More importantly, an
export-led climb by profits will sustain a brisk pace of hiring activity that will stoke wages and salaries.
After most recently bottoming at the 6.2% of the quarter-ended May 1999, the annual growth rate of
total wage and salary income has since climbed up to the 6.6% of the quarter-end August, which matched
the rate of growth for consumer spending. From the perspective of wages and salaries, the latest annual
increase of current-dollar consumer spending appears to be sustainable. The hiring activity stemming
from the possibly steeper climb of corporate earnings should extend wage and salary income's vibrant
advance.
The annual growth rate of current-dollar consumer spending has hardly dipped beneath its 6.9% peak of
the quarter-ended April 1999. As derived from an estimated 75% of the month's total sales, September's
preliminary 9.9% year-to-year advance by unit sales of US-built light motor vehicles upholds the
continuation of a brisk pace of US household expenditures. Until consumer spending sags noticeably,
higher interest rates are likely.
Consumer Confidence Remains In Its Top Decile
The Conference Board's index of consumer confidence dipped from August's upwardly revised score of
136 to a still strong 134.2 for September. Not only did September's consumer confidence index top its
trailing 12-month average for an eighth straight month, but September's reading put the consumer
confidence index's 3rd-quarter 1999 average in the statistic's top decile of all time.
Well above-trend readings on consumer confidence imply exactly the same for real household
expenditures. For observations conforming to this top decile, the results show very rapid gains being
posted by broad measures of real household expenditures.
On a quarter-to-quarter annualized basis, the top decile's average rates of increase were 4.8% for real
consumer spending and 12.3% for real residential investment. Year-to-year, consumer confidence's top
decile was associated with average advances of 4.6% for real consumer spending and of 7.9% for real
residential investment. The remaining 90% of a nearly 33-year sample, yielded average annual increases
of 3.1% for real consumer spending and of 3.4% for real residential investment.
Home Sales Boom Sans Speculative Bidding
The consensus had been looking for a decline. Instead, new home sales advanced by 2.9% monthly to
August's annualized pace of 983,000 units -- the second best reading ever. Despite how the FHLMC's
30-year mortgage yield advanced from the 6.92% of August 1998 to the 7.94% of August 1999, new
home sales would still rocket higher by 17.6% year-to-year.
Mortgage yields last entered into a year-to-year advance of at least a percentage point in May 1994. The
jump in borrowing costs did not stop new home sales from climbing higher by 10.4% annually in May
1994.
Current economic and financial market behavior increasingly resembles what transpired in 1994.
Investors should not rush to declare the nearness of a peak for Treasury bond yields. In the end, we will
probably all be surprised at the ultimate height of the climb by Treasury bond yields. At their turning
points, Treasury yields have often moved above (or under) what was warranted by underlying
macroeconomic conditions.
Robust home sales bode well for consumer spending into the year 2000. Perhaps the 30-year Treasury
yield needs to climb above 6.5% in the US economy is the slow appreciably.
August's yearly decline by the median sales price was probably a freak occurrence. The annual rate of
growth for the median selling price of new homes should soon approach the 4.2% median sales price
increase of existing homes for the quarter-ended August.
Nevertheless, the prices of new homes are not climbing rapidly enough to disturb Fed policymakers. The
bidding for new homes was much more inflationary during the 9 months ended March 1988, or when the
median sales price of new homes soared higher by nearly 16% annually, on average.
Because of August's 2.6% annual setback, the median selling price for new homes rose by only 2.8%
annually during the quarter-ended August. However, the same serial comparison showed the average
selling price of new homes jumping higher by 7%. From the perspective of median selling prices, new
homes topped existing homes by merely 9.5% in August, which was the smallest such premium since
August 1985. The then paltry 3.5% annual rise by the median sales price of new homes would leap up to
8.1% by 1985's final quarter.
Private-Sector Debt Surges In Both Europe And The US
Private-sector credit has been expanding rapidly throughout much of Europe. In the UK, August's total
amount of outstanding personal debt was up by 8.4% year-to-year, wherein consumer credit advanced by
14.1% annually. For the longest time, some analysts have bemoaned the rapid climb of British consumer
credit and, yet, household expenditures in the UK still prosper.
According to the Euro-zone's faster annual increases of 5.7% for the M3 monetary aggregate and of
7.8% for total credit, the now 3%-3.5% annual increase of the EU-11's nominal GDP can only move
higher.
The European Central Bank (ECB) reports that the Euro-zone's total private-sector debt outstanding
grew by 10.7% annually, to August's 5,905 billion euros. By contrast, the Euro-zone's outstanding
public-sector debt inched higher by merely 0.2% annually in August to 2,038 billion euros. The
acceleration of private- relative to public-sector debt would support a widening of corporate bond yields
over government yields in the EU-11.
Among nonfinancial borrowers, the public sector supplies $4.89 trillion, or 29.2%, of the US' $16.76
trillion of outstanding debt. For the Euro-zone, the public sector supplies a strikingly similar 25.7% of
outstanding debt.
The US' outstandings of June 1999 showed vastly different year-to-year changes of -0.6% for
public-sector debt and of +9.7% for private-sector debt. The yearly increase of US private-sector debt
recently crested at the 10% of March 1999. For US nonfinancial-sector obligations, public-sector debt
would peak at 36.2% of total debt outstanding in March 1994. Government credit now comprises the
smallest share of total debt since the 29.1% of year-end 1982.
Real Bond Yields Are Market Driven
The latest climb by real bond yields rates may not be significant. There is no such thing as equilibrium for
the real rate of interest. As of second quarter, the "real" interest rate, the difference between the 10-year
Treasury bond less the annual rate of core CPI inflation, reached 3.4%. This rate is above the real
interest rate's 2.8% average since 1965, but it there is probably very little substance to the meaning of
such a comparison. Real interest rates tend to be fairly volatile, and since 1965 have a standard deviation
of 2.2%. That means that the latest 3.4% real interest rate, because of its high variability, is not
significantly different from zero.
Real interest rates will vary directly directly with the strength of business activity, the demand for credit,
and the risk-adjusted returns expected from other investments including the possibly lucrative
introduction of new technologies.
Smashing Another Credit Market's Myth
Misconceptions abound, mostly because of a tendancy not to admit to the complexity of markets.
Financial markets are an extension of life, and both are inherently messy.
Setting aside all else, Treasury yields ought to be lower the smaller US government indebtedness is
relative to the overall economy. But, whirl is king. Fluctuations in the financial and economic
environment are unending. Investment strategies that are based on the movement of a single economic
variable risk being too narrowly focussed.
According to lore, Treasury bond yields will rise and fall as US government debt outstanding expands and
contracts relative to the overall economy. Despite how US government debt would drop from
early-1965's 37.3% to September 1981's 24.8% of GDP, the 10-year Treasury yield would still soar
higher -- from its 4.20% average of 1965's first quarter to the 14.85% zenith of 1981's third quarter.
During that extended span, the 10-year Treasury yield would actually jump up from the 5.77% of 1968's
final quarter to the 7.30% of 1969's final quarter notwithstanding how 1968's 16.1 billion federal budget
deficit would be followed by a $5.4 billion surplus.
More than supply shapes the yields of US governments and corporate bonds. Despite how US
government debt surged from third-quarter 1981's 24.8% to a first-quarter 1994 apex of 49.9%, the
corresponding 10-year Treasury yield averages would plummet from 14.85% to 6.07%.
Most recently, notwithstanding a rise by the federal budget surplus from fiscal year 1998's $69.2 billion
to fiscal 1999's prospective $155 billion, the latest 10-year Treasury of 5.98% tops its 1998 average of
5.3%. Rising inflation risks would push Treasury yields sharply higher from the mid-1960s to the
early-1980s despite US government debt's decline relative to the overall economy. Thereafter,
record-smashing budget deficits would not stop Treasury yields from entering into an extended slide.
For macroeconomic theory, exceptions are the rule.
When the US' current account deficit rose to an unprecedented 3.5% of GDP during 1986-1987, analysts
were quick to note how the then gaping trade deficit was the logical offshoot of a record federal budget
deficit. Such reasoning has proven to be quite shallow as shown by the now unprecedented girth of the
US' current account deficit relative to GDP despite how the US' federal budget has plunged from 1985's
-5.2% to the latest +1.1% of GDP.
Ratio Of Corporate Debt To Profits Falls Far Short Of Previous Highs
The ratio of corporate debt to operating profits has climbed up from its most recent lows but falls short of
it highs of the 1990-1991 recession and of the 1984-1989 years of high leverage. For 1999's second
quarter, the outstanding debt of US nonfinancial corporations approximated 643% of their operating
profits, which was up from the first-quarter's 633% and the ratio's 593% average for 1998. This measure
of the relative size of corporate debt bottomed at the 554% of 1997's third quarter. Just prior to that
observation, a composite corporate bond yield spread of investment- and speculative-grade issues
bottomed at the 118 basis points of 1997's first quarter. After peaking at the 231 basis points of 1998's
tumultuous final quarter, the composite corporate yield spread would drop to the 195 points of 1999's
second quarter, which was still well above its long-term average of 169 points.
Corporate debt peaked at 841% of operating profits in 1991, or not long after the composite corporate
yield spread formed a top of 298 basis points in the final quarter of 1990. The latest ratio of corporate
debt to operating profits still trails the 805% of early 1987, or when net corporate bond offerings last
boomed. The 227 basis points corporate bond yield spread of 1987's first was down from 1986's
second-quarter peak of 283 points.
Mortgage Applications' Slump Foreshadows A Peaking Of Yields
Distracted by the mammoth additions to wealth following from a stupendous stock market rally, analysts
have often overlooked the benefits flowing to consumer expenditures from 1998's unparalleled 232%
annual surge by applications for mortgage refinancings.
Many of the economic pessimists and Treasury bond bulls of late-1998 ultimately looked foolish for
having discounted the stimulatory implications of 1998's stunning climb by mortgage refinancing activity.
Do not ignore the converse of such an error. The latest retreat by mortgage refinancings warns of
1999-to-date's 8.7% year-over-year advance by retail sales eventually converging towards the
accompanying 6.4% growth of wage and salary income.
In the US, consumer outlays on big-ticket items ought to slow noticeably in 2000. The Mortgage Bankers
Association's (MBA) index of applications for mortgage refinancings was down by 71% year-over-year
for the 13-weeks ended September 24th, while, at the same time, mortgage applications for the purchase
of a home eked out a comparably measured gain of 3%.
During the 4-weeks ended September 24th, the MBA's index of mortgage inquiries from potential
homebuyers was off by 9.4% annually. Homebuyers mortgage applications have entered into their
deepest annual setback since April 1994. Treasury bond yields would not peak until November 1994.
Also, for the 4-weeks ended September 24th, applications for mortgage refinancings plummeted by
82.5% annually implying that this index has entered into its deepest such collapse since June 1994. The
recent contractions by mortgage applications suggest that peak for Treasury yields may be no more than
6 months away.
For the first time in a long while, both major weekly surveys reported US retail chain sales as being
at-or-below plan. A sizeable unwanted accumulation of inventories would bode poorly for new orders,
imports, and US industrial activity.
Investors Will Focus More On Stock Buyback Capacity
Fed researchers now sense that the end will not draw near for the US' stupendous stock market rally until
companies have largely exhausted their capacity to finance equity buybacks. Reportedly, a new Fed study
estimates that major stock price indices might plunge by as much as 33% if equity buybacks were to halt.
As derived from the Federal Reserve's Flow of Funds date, the record $315 billion net retirement of US
equity shares for the year-ended June 1999 approximated an unprecedented 3.6% of GDP. During the
previous economic recovery, net equity retirements peaked at 2.6% of GDP during the year-ended
September 1989.
In conjunction with the de-leveraging phenomenon of the early 1990s, net equity retirements would be
supplanted by the net issuance of equity shares, where net equity offerings would peak at the 1.3% of
GDP for the 12-months ended September 1992. As net equity buybacks dropped from 1989's peak to
1992's bottom, the 12-month change of the S&P 500 stock price index would plummet from the +34.4%
of August 1989 to the -12.3% of September 1990. By the time net equity retirements bottomed, the S&P
500 stock price index had recovered to the 7.7% year-to-year gain of September 1992.
John Lonski, chief economist |
