Interest Rate Uncertainties Mount
John Lonski, Moody's senior economist in New York
moodys.com
At February's Humphrey-Hawkins testimony, Allan Greenspan reiterated the importance of curbing domestic spending for the purpose of avoiding an inflationary escalation of wages and salaries. A peak for short- and long-term interest rates may not impend until the labor market no longer tightens.
When gauging inflation risks, the Federal Reserve focuses much more intensely on wages and salaries than on industrial
commodity prices. Labor costs well exceed those of all intermediate and crude materials combined. For US nonfinancial corporations, employee compensation approximates 64% of their gross product. Recent advances by industrial commodity prices may be more reflective of livelier world expenditures than the harbinger of faster price growth for final goods and services.
The Fed chairman noted that household expenditures have been able to outpace personal income both because of the still relatively inexpensive foreign funding of a now record current account deficit and because of the rapid accumulation of wealth arising from unprecedented stock price appreciation. Those same productivity gains that have kept inflation low by swamping the growth of labor compensation have also boosted the market valuation of equities by enough to leave many Americans rich beyond belief. As advances in technology expand the economy's long-term potential, investors are apt to assign a higher value to both revenues and profits.
If the Fed succeeds at curbing domestic spending, at least some important segments of the equity market will probably suffer. For one thing, higher yielding credit market instruments will lessen investor demand for stocks. Moreover, profitability will be harmed by the loss of sales to steeper borrowing costs. The earnings of companies owing substantial amounts of variable-rate debt may be especially vulnerable.
Current Account Gap Widens Yield Spread Between US And Foreign Bonds
US government bond yields have tended to be steeper relative to the average government bond yields of other G6 countries the wider is the US' current account deficit. When the US current account deficit averaged 2.9% of GDP during 1984-1988, the US' 10-year Treasury yield averaged 151 basis points more than the average 10-year government bond yield of the other G6 countries -- Japan, Germany, France, the UK, and Italy. In response to the US' current account deficit dropping to 1% of GDP during 1989-1993, the 10-year Treasury yield would instead trail the average government bond yield of the other G6 countries by 33 basis points, on average.
As the US' current account deficit climbed up from 1995's 1.5% to 1999's prospective record 3.6% of GDP, the gap between the US' 10-year Treasury yield and the "other G6" yield widened from 1995's three basis points to 1999's 215 points, which was the broadest since 1984's 263 points. As of February 17th, the 6.57% 10-year US Treasury yield was 235 basis points above the average government bond yield of the other G6 countries.
The now very wide gap between US and foreign government bond yields reflects the much faster growth of US expenditures, which has been the driving force behind the widening of the US' trade gap. Not until US borrowing costs become more burdensome might a relative slowing of US expenditures begin to thin the US' current account gap. As prospective returns from non-US assets rise in response to the improved economic performance of the rest of the world, the costs of funding the US' current account deficit will rise as foreign investors demand higher returns from US investments.
Foreign Net Lending To US Subsides
The consensus expects a widening of the US' inflation-adjusted trade deficit from 1999's $324 billion to 2000's $369 billion. In turn, the US' current account deficit would rise from 1999's prospective 3.6% of GDP to nearly 4% in 2000.
Just as the US' current account deficit has been setting new records, foreign net lending to the US has subsided. The four-quarter running sum of foreign net lending to the US had earlier soared from year-end 1991's $31 billion to its $395 billion zenith of the span ended September 1997. When the net supply of credit market funds from abroad approximated 4.8% of GDP for the year ended September 1997, the US current account deficit was a relatively small 1.6% of GDP. For all of 1999, the US' net borrowing from foreigners probably fell to $263 billion, or 2.8% of GDP, while at the same time, the US' current account deficit may have swelled to 3.6% of GDP.
Unprecedented foreign net investment in US credit market instruments may help to explain 1997's pronounced narrowing of corporate bond yield spreads. The huge inflow of foreign capital during 1996-1997 heightened the liquidity of the US credit market. Compared to a long-term average of 105 basis points, the yield spread over Treasuries of long-term, investment-grade industrial company bonds would bottom at 83 basis points in 1997. Even more dramatic was the narrowing of Moody's below-investment-grade yield spread over Treasuries to 1997's 289 basis points average, compared to a long-term mean of 410 points.
In response to the steepness of corporate bond yields compared to Treasury yields and to the stepped-up issuance of very large global bonds by US corporations, foreign net buying of US corporate bonds approached a record $130 billion for the year ended September 1999.
Business Sales Soar Absent Much Help From Exports
The magnitude of the 8.7% year-over-year increase by total business sales of 1999's final quarter owed something to its meager 3.6% yearly rise of 1998's final quarter. The year-to-year comparisons of business sales and of corporate earnings will get less support from year-earlier weakness as 2000 progresses. Still, the business sales of 1999's fourth quarter posted their steepest annual increase since peaking at the 9.2% of 1995's first quarter.
All of the platitudes regarding recent gains in productivity and attendant declines in unit labor costs cannot disguise how the available results show fourth-quarter 1999's 13.1% yearly increase by the recurring profits of 1,208 US nonbank companies lagging far behind first-quarter 1995's 26.1% annual surge by the core earnings 1,667 nonbank companies.
The latest performance by recurring corporate profits may lag its much livelier showing of 1994-1995 partly because of a now flatter rise for exports.
The 17% annual advance by imports of 1999's final quarter practically matched its climb of 1995's first quarter. The big difference in annual growth rates applied to exports, whose 5.5% gain of 1999's fourth quarter was but a fraction of first-quarter 1995's 15%.
As foreign expenditures quicken, US corporate earnings should benefit from export acceleration, the enhanced profitability of overseas operations, a lessening of competitive pressures from imports, and firmer product prices.
The brisk growth of US corporate earnings could heighten the incentive to expand production capabilities, which would sustain a brisk pace of capital spending and underpin hiring activity. Given an already tight labor market, adding to the demand for labor is likely to put more upward pressure on wages and salaries.
February's survey of regional manufacturers by the Philadelphia Federal Reserve Bank detected a firming of planned capital spending. February's index of planned capital spending in the Philadelphia Fed's District was at 38 -- up from its 21.3-point average of the 12 previous months and its highest reading in more than 10 years. For the quarter-ended February, this barometer of capital spending intentions averaged 26.3.
For now, the evidence portends nothing worse than a mild slowing of capital spending in 2000. New orders for nondefense capital goods excluding commercial aircraft bookings grew by 8.7% annually in 1999's final quarter, which bettered its 7.1% increase of year-long 1999.
Business equipment production was up by 5.6% year-over-year for the quarter ended January 2000, which looked limp compared to 1999's year-long increase of 6.3% and the category's 10.5% average annual advance of 1996-1998. Still, the annual increase for the manufacture of business equipment was up from its 4.2% bottom of the quarter ended November 1999.
The annual increase for the manufacture of computers (and office equipment) has slowed from its 84.8% zenith of the quarter-ended November 1998 to the 49.8% of the quarter-ended January 2000. The annual increase for the production of business equipment other than computers peaked some time ago at the 11.1% of the quarter-ended November 1997 and would eventually bottom with the 1.4% annual contraction of the quarter ended November 1999. For January 2000, the manufacture of business equipment excluding computers was up by 1.8% yearly -- the category's first annual rise since July 1999.
The growth of computing power has supplied an upward bias to the production of computer equipment. The year-long results for 1999 showed annual increases of 58% for the production of computers and of 44% for real business investment in computers, both of which were much greater than the 11% increase for current-dollar business investment in computers. Also, computer equipment's current-dollar results for 1999 showed both new orders and shipments growing by 7%.
After dipping around mid-1999, new bookings for computer equipment have climbed higher. In unadjusted current-dollar terms, the annual increase of new orders for office and computing equipment peaked at the 24.7% of the quarter-ended August 1998 and would then slide to the 5.1% of 1999's second quarter. In 1999's final quarter, new orders for office and computing equipment edged back up to 7.8% annually. The annual change of new orders for industrial machinery and equipment excluding computers improved from the -0.1% of 1999's first quarter to the +6.9% of the final quarter.
Low Inventory-To-Sales Ratio Brightens Economic Outlook
Favoring an expansion of business operations is the lowest inventory-to-sales ratio ever and the lengthening of unfilled orders for those durable goods having a more immediate impact of manufacturing activity.
During the three months ended December 1999, inventories grew by $21.1 billion, which was up from third quarter 1999's $11.7 billion and was the biggest such gain of any calendar-year quarter since the $25.7 billion of 1995's first quarter. Nevertheless, fourth-quarter 1999's addition to inventories approximated 81% of the accompanying dollar-increase in business sales, while first quarter 1995's inventory accumulation was nearly 4.5-times the size of the comparable gain in business sales. When inventories grow much more rapidly than business sales -- as in 1995's first quarter -- industrial activity invariably decelerates.
Fourth quarter 1999's 8.7% annual advance by business sales outpaced December 1999's 4.6% yearly increase for inventories by enough to improve 2000's manufacturing prospects. If sales outrun inventories, less downward pressure will be put on prices by unwanted stocks of unsold goods.
Also, the faster growth of new orders relative to both inventories and production capabilities has prompted a major transformation of the annual change of unfilled orders for "impact" durable goods from December 1998's 0.9% contraction to December 1999's 11.7% advance. The latest acceleration of orders' backlogs is tangible evidence of demand's more rapid expansion compared to supply.
Several Imbalances Favor Livelier Industrial Activity
During the last 15 years, real consumer spending's 3.6% average annual increase bettered the 2% average annual rise by the US' manufacture of consumer goods. In a noteworthy divergence from this trend, 1998-1999 revealed a far-above-average 6.6% average annual advance by real spending of consumer goods towering over a well below-trend 0.9% average yearly rise for consumer goods production.
Although import acceleration helps to explain the striking split between booming outlays on consumer goods and the slumping production of consumer goods, the annual change of consumer goods production has recovered from its 0.9% contraction of 1998's fourth quarter to the 2.1% gain of 1999's fourth quarter. Because fourth-quarter 1999's annual increase by consumer goods output still trailed real spending on consumer goods' 6.9% annual advance by an atypically wide margin, a further acceleration of consumer goods production might be expected.
More than a recovery by consumer goods production can be expected to boost the annual increase of US industrial output from 1999's 3.5% to 2000's 4.9%. In addition, US manufacturing stands to be invigorated by the unfolding recovery by exports.
When real exports grew by 10.2% per year, on average, during the four-years ended March 1998, US factory output would expand by 6% annually, on average. The thinning of the US' record current account deficit will probably require a yearly rate of real exports growth that eventually well exceeds the 4% of 1999's final quarter.
Further, a narrowing of the US' current account deficit should eventually be accompanied by dollar exchange rate depreciation that might benefit US manufacturers by simultaneously boosting exports and curbing imports. The annual increase of US manufacturing output has already recovered from its 3.5% bottom of 1999's first quarter to the 4.7% of 1999's fourth quarter despite the far from
complete recovery by US exports.
Housing Activity Defies Sharply Higher Mortgage Yields
Any slowing of housing activity in response to the steepest 30-year mortgage yields since mid-1996 has been quite mild. As of February 11th, the Mortgage Bankers Association's (MBA) average effective 30-year mortgage yield was at 8.66% -- up by 149 basis points yearly. Also, the 1-year adjustable rate mortgage yield rose by a similarly steep 140-points, to 7.53%.
In sharp contrast to what otherwise might be inferred from so steep of a climb by mortgage yields, the MBA's index of mortgage applications for the purchase of a home was up by 11.5% annually during the four-weeks-ended February 11th. The latest available four-week span also showed homebuyer mortgage applications advancing by 11.4% from their average of the four weeks ended January 14,2000.
Housing activity has yet to fade in a manner that would lend support to forecasts of an impending peak for bond yields. At odds with a recent consensus forecast of a 7% annual decline by 2000's housing starts was the 9% year-over-year increase by mortgage applications for the purchase of a home since year-end 1999.
Although January 2000's housing starts topped their average monthly seasonally-adjusted pace of the 12-previous months by 6%, they were off by 1.6% from the very robust tally of January 1999. In January 2000, housing starts proceeded at an annualized pace of 1.775-million units -- compared to 1999's year-long 1.674-million and the latest consensus forecast of 1.55-million starts for 2000.
Suggesting that the strong showing by housing starts was not an aberration was January's accompanying 8.7% monthly jump by building permits to an annualized rate of 1.763-million units -- well above year-long 1999's 1.631-million units. Nevertheless, for the quarter-ended January 2000, housing starts dipped by 1.3% yearly, while permits fell by 3.4%.
Starts and permits may not be housing's best indicators of interest rate trends. When the last major upswing by bond yields was peaking during 1994's final quarter, the year-to-year gains of 2.7% for housing starts and of 0.7% for permits contrasted with the concurrent setbacks of 9.8% for total home sales and of 17.8% for homebuyer mortgage applications. Also, during 1994's fourth-quarter, the MBA's index of applications for mortgage refinancings plummeted by 91% annually.
The National Association of Home Builders' (NAHB) housing market index fell from January 2000's 71 to a still very expansionary score of 68 in February. Higher interest rates may finally be diminishing the enthusiasm of homebuilders. However, except for 1999's record 73 and 1998's 70, February's score would still exceed each of the housing market index's previous annual averages for a record that begins in 1985.
During the previous major upswing by interest rates, bond yields would not crest until the housing market index sank from December 1993's 70 to the 48 of November 1994. By November 1994, the NAHB's housing market index had also dropped 11.2-points under the NAPM's manufacturing index, which, like the housing market barometer is a diffusion index.
Far different was January 2000's 14.7-point premium of the NAHB's housing market index over the NAPM's manufacturing activity index. In the past, whenever the NAHB index was at least 10 points above the NAPM index, manufacturing activity would eventually gather speed. Apparently, interest rates have not yet climbed high enough to materially slacken US business activity.
Federal Tax Data Hints Of Upward Revision For Personal Income
The US government's collection of personal income plus payroll-related taxes advanced by 11.8% annually for the quarter-ended January 2000. Not since the 12.1% annual increase of 1998's second quarter has the sum of personal income and employment-related taxes grown so sharply. Around that time, the annual growth rate of wage and salary income was climbing up from second-quarter 1998's 7.7% to its 7.9% apex of the third quarter.
Despite how the annual increase of personal income plus payroll-related tax receipts has increased from the 5.9% of 1999's second quarter to the 11.8% of the quarter-ended January 2000, the US government estimates that the annual increase of wage and salary income has slowed from second-quarter 1999's 6.9% to the 6.5% of the quarter-ended January 2000.
According to the latest news on federal tax revenues, existing wage and salary estimates ultimately should be revised sharply higher. If the personal savings is steeper than current data indicate, then consumer spending's outlook is brighter.
The latest drop by bond yields in response to an equity market correction should lengthen the stay by robust household expenditures. February's drop by the 10-year Treasury yield is likely to be more than reversed in reaction to a further tightening of the US labor market amid fast rising expenditures in the US and elsewhere.
Fewer Mortgage Refinancings Warn Of Slower Spending
Sticking out among mostly upbeat indicators of consumer spending has been the 75% annual drop by applications for mortgage refinancings of 2000-to-date. A dwindling number of mortgage refinancings imply that household expenditures will receive less support from an extraordinary augmentation of homeowners' cash flow. Also, consumer credit worth may be adversely affected by the much-reduced scope for cutting household interest costs through the refinancing of outstanding mortgages.
Results taken from the four weeks ended February 11th showed applications for mortgage refinancings growing by 16%, on average, compared to the contiguous four-weeks, but plunging by 75% annually.
Sales of big-ticket items have been directly correlated with mortgage refinancings. In part, 1999's steep 9.1% annual advance by unit sales of light motor vehicle in the US could be ascribed to 1998's 232% annual surge by applications for mortgage refinancings.
Surprisingly, unit sales of light motor vehicles in the US managed to advance by 10.1% yearly in January 2000 despite 1999's 54% year-long contraction of mortgage refinancings. Questioning the durability of January's blistering sales pace is the consensus' latest forecast of a 3% annual drop by motor vehicle sales in 2000.
Higher Rates Of Capacity Utilization Impend
The yearly growth rate of industrial production has climbed up from its most recent 2.6% bottom of the quarter-ended February 1999 to the 4.8% of the quarter-ended January 2000. A year ago, January 1999's 80.4% rate of industrial capacity utilization was off by 2.9 percentage points from its year earlier reading. The rate of industrial capacity utilization has recovered to January 2000's 81.6%, which remains well under its most recent high of 84.4% from January 1995.
If current rates of manufacturing capacity utilization resembled the now high rates of labor market utilization, inflation risks would be greater and interest rates would be higher. Already a number of industrial commodity prices have been pushed upward by an unfinished enlivening of manufacturing activity worldwide. No longer does a flat-to-lower rate of industrial capacity utilization help to counter the inflationary implications of a tighter labor market.
The 10-year Treasury yield has tended to rise and fall with the rate of industrial capacity utilization. When the rate of industrial capacity utilization was climbing up to its latest 84% high of 1995's first quarter, the 10-year Treasury yield had just peaked at fourth-quarter 1994's 7.8%. Moreover, in the process of tumbling down to the 80.4% low of 1999's first quarter, a slackening of industrial activity would help to guide the 10-year Treasury yield down to a 30-year low of 4.7% for 1998's fourth quarter. The more intensive utilization of production capacity should be accompanied by an even lower unemployment rate, which would practically assure another upswing, by the 10-year Treasury yield.
Japan's Economy Still Struggles To Attain Respectable Growth
The latest slide by Japan's annual rate of M2 growth from June 1999's 4.3% to January 2000's 2.6% hints of a troubling slowdown in Japanese domestic spending. Beginning in 1984, the eight strongest years of M2 growth showed average annual growth rates of 9.1% for M2 and of 3.6% for Japan's real GDP, while the span's eight lowest annual rates of M2 growth averaged 2.5%, which was associated with a 1.8% average yearly rise for real GDP.
For US corporate credit rating revisions in 1999, downgrades were concentrated among smaller companies and vice versa. In terms of the number of rating actions affecting US corporate credit ratings, 1999's results showed only 55 upgrades per 100 downgrades. However, in terms of the par value amount of non-money-market securities affected by US corporate credit rating revisions, $110 of bonds were upgraded for every $100 of downgrades.
In 1999,the average US corporate credit rating downgrade affected $625 million of bonds, while the average upgrade applied to $1,262 million. The average par value amount of non-money-market securities affected by a US corporate credit ratings downgrade was the smallest since 1989's $614 million and was down from 1998's $1,137 million, while 1999's average amount of bond-upgrades was under 1998's record $2,448 million.
In a manner similar to what has befallen US corporate credit rating changes, the average amount of debt affected by a Japanese corporate bankruptcy has been declining. January 2000's 43.7% year-to-year jump in the number of corporate bankruptcies was joined by a 19.7% yearly drop in the amount of debt linked to a bankrupt Japanese business.
For all of 1999, the number of Japanese corporate bankruptcies fell by 19.4% annually, while the yen-amount of debt affected by these insolvencies was off by a shallower 5.8% year-over-year. However, for the quarter-ended January 2000, the 23.4% year-to-year advance in the number of Japanese corporate insolvencies diverged from the concurrent 44% plunge in the amount of debt affected.
All else the same, the bankruptcy of a smaller company ought to be less disruptive to overall business activity than the bankruptcy of a larger company. Still, the pace of Japanese business activity does not inspire confidence. Private-sector spending in Japan cannot yet break free of the many insecurities stemming from unprecedented corporate restructuring.
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John Lonski, chief economist |
