| Barron's
Current Yield: Markets Voice Doubts About The Fed's Optimism
(From BARRON'S)
Turning point or, perhaps, tipping point? That is the
question weighing on the financial markets about the strength of the economic
recovery.
Last week the Federal Reserve, as widely expected, increased interest
rates by a quarter-percentage-point, its second such move this year, to lift the
fed-funds rate target to 1.50%.
And the Fed's policy-setting committee's
accompanying statement declared that the economy would soon return to a "stronger
pace" of growth,heavily implying that a moderation in growth would not deter
policymakers from slowing the pace of rate increases.
Even so, doubts about
the vigor of the economic expansion continued to
intensify.
"I don't
think the economy is poised to grow as fast as what the Fed committee is forecasting,"
says Mary Ann Hurley, vice president of fixed-income trading at D.A. Davidson.
"The economy is very dependent on low interest rates, and in the absence
of strong job growth, marginal wage gains, limited refinancing proceeds and no
fiscal stimulus, the economy is going to struggle."
Moreover, she questions
the Fed's assumption that the rise in oil prices, another drag on growth, is temporary.
In the Fed committee's statement, it said that "in recent months, output
growth has moderated and the pace of improvement in labor market conditions has
slowed." Policymakers put the blame for much of that weakness on "the
substantial rise in energy prices."
Two days later, crude oil prices
in New York hit a record $45.75 a barrel, climbing further on Friday to break
through $46 on the New York Mercantile Exchange.
"If energy prices move
higher, which is not an unreasonable concern, that would be a serious threat to
the expansion," says Mark Zandi, chief economist at Economy.com.
He
believes the Fed last week was attempting to shore up what looks to be "very
fragile business confidence, because that is key to hiring."
Business
confidence is "measurably better" today than a year ago, says Zandi.
"But it's tentative confidence that we are seeing. Businesses are very quick
to scale back at any time if there are any signs that sales and business conditions
aren't measuring up to expectations."
That was highlighted in the shockingly
weak July employment report, which showed an increase of 32,000 nonfarm jobs,
well below market expectations of 240,000, he says, noting that weakness was concentrated
in retail and mortgage banking.
"The Fed must be banking on a decline
in oil prices in order to achieve its result," agrees Robert Spector, senior
economist at Merrill Lynch. "The main takeaway is that the Fed seems unhappy
with a negative real fed-funds rate and appears ready to look through what they
perceive to be near-term economic weakness while they eliminate this gap in quarter-point
increments."
On Friday, fed-funds futures indicated a 73% probability
that at its next meeting, on Sept. 21, the Federal Open Market Committee would
vote a quarter-point increase, to 1.75%, in the Fed's target for the overnight
money
rate. The meeting will be the committee's last before the presidential
election.
That probability was 50% before last week's meeting.
Coming
off of Fed Chairman Alan Greenspan's bullish mid-July congressional testimony,
"the Fed needed to stay the course to maintain credibility and avoid waffling
if one or two months of numbers don't conform to their baseline forecasts,"
says Spector. "They would need serious evidence that the economy is really
decelerating."
Fed policymakers see the economy expanding between 4.5%
and 4.75% through the fourth quarter of this year from the previous year.
But a growing number of economists have lowered their forecasts for the second
half, partly reflecting the headwinds confronting the economy, including geopolitical
risks and high oil prices. On Friday, economists at the ISI Group lowered their
forecast for real gross domestic product to 3.5% from 4% earlier this year.
They aren't alone. The Treasury market also did some reevaluating.
Yields
on Treasury notes and bonds plunged at the end of last week, calling into question
the Fed's view that growth will reaccelerate strongly.
"If the bond
market is taking the Fed's word verbatim, then why is it trading at the high end
of the range at 4.20% on the 10-year note rather than at 4.75%-5%?" wonders
D.A. Davidson's Hurley. "Treasuries aren't up only because of high oil prices.
The spike in oil is compounding the other problems facing the economy. The bond
market is skeptical," she adds.
Treasury prices, which move inversely
to yields, rose even in the face of a $14 billion auction of 10-year notes, nearly
55% of them purchased by indirect bidders, including foreign central banks and
customers of primary dealers.
The yield on the benchmark 10-year T-note settled
at 4.22% on Friday, down from when-issued trading on the new note at 4.27% on
Thursday.
The yield on the 30-year bond settled Friday at 5.01%, down from
5.03% the previous Friday. As typically happens when monetary policy is tightened,
the result was a flatter yield curve, with short-term rates rising faster relative
to the yield on the longer bond yield.
The yield on the two-year note, the
maturity most sensitive to moves by the Fed, settled Friday at 2.48%, up from
2.38% one week ago.
"The news is starting to catch up to world rate
markets," wrote Peter
Mc-Teague, interest-rate strategist at RBS Greenwich
Capital, in a Friday note to clients commenting on the synchronized global slowdown.
"Growth has done a down-shift in various corners, particularly the U.S. and
Japan. But with Asia, it is also being weighed on by China slowing and high oil
-- all part of the fuel to weak equities."
GDP in Japan posted only
a 0.4% gain in the second quarter, well below
expectations of a 1.0% increase,
fueling a rally in Japanese government bonds.
The yield on the benchmark 10-year
JGB closed Friday at 1.56%, down 0.12 of a percentage point from the previous
Friday, while the Nikkei dropped to a three-month low.
Meanwhile, the U.S.
trade deficit swelled to a record $55.8 billion in June, surpassing expectations
of $47 billion, as imports of crude oil and industrial supplies surged and slowing
growth in Japan and Europe curbed export demand.
"Friday's news on the
record trade deficit will negatively impact second quarter GDP and will more than
offset" the bright news on consumption and inventories the day before, observes
Hurley. "Look for the 3.0% increase in second-quarter GDP to be revised lower.
The trade deficit is a major imbalance to the economy. At some point, foreigners
could demand a higher price, meaning higher interest rates, to keep their funds
in dollars."
For now, however, given the mad rush to load up on Treasuries,
the U.S. seems a safe haven relative to the rest of the world.
because boring
has become beautiful, investors shouldn't bypass municipal bonds. "Municipal
bonds, 10 years and longer, continue to look attractive versus taxable alternatives,"
says Mary Miller, director of fixed-income at T. Rowe Price.
To be sure,
the credit markets have seen yield spreads narrow sharply for many of the major
taxable sectors, including corporate bonds and junk debt.
The average 10-year
triple-A municipal bond -- whose interest is exempt from federal income tax and,
for residents of the state where the bond was issued, usually from state and local
income tax -- yields 85% of what you would get from a Treasury bond of the same
maturity. That makes tax-exempts cheaper relative to their taxable counterparts.
"It's even more attractive in longer-term maturities and lower-rated
credits," says Miller. She notes that 30-year double-A municipal bonds yield
about 95% of Treasuries. In addition, new issuance in the municipal market has
fallen 20% from last summer's level. That, some say, could create a strong bid
to the market.
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