Inflation and bond yields to head
higher
George Dagnino, Ph.D., Editor
The Peter Dag Portfolio Strategy and Management
There
is no doubt in my mind that inflation and bond yields are heading higher.
The
press and Wall Street are celebrating the fact that inflation news is great.
The outcome was that bond yields declined 17 basis points to 6.18%, down
from 6.35%, and the stock market soared 5%.
A
strong economy and low inflation are what the markets needed. Index prices
soared: their reaction was hard to believe and even harder to accept. Let's
rejoice. The reason for the sudden bullishness is that actual inflation
was slightly lower than anticipated. What is incredible is that no one worries
about what the actual level of inflation is.
All
the data released so far show inflation is running at close to 4% (see below).
This figure is more than 300% higher than the inflation level of 1.5% of
last year, at its cyclical low. In other words, inflation has more than
tripled and the markets are rejoicing because the data show inflation is
lower than anticipated.
What
is being ignored is that the business cycle is in full swing, economic growth
is very strong well above its long-term average. Resources are being utilized
to their full extent and imbalances are fast becoming an issue. For instance,
higher interest rates are already causing serious problems for the housing
sector (see below).
The
bulls believe the economy is slowing down because of weak reports from the
construction sector (see below). It is true the economy is downshifting,
but this situation is temporary. Business activity jumped 4.8% last quarter.
It should come as no surprise that business activity is pausing, as it did
in the second quarter, following a torrid first quarter.
I
believe the odds favor a strong economy well into 2000, expanding at above
its long-term average. The outcome will be further upward pressure on inflation.
Rising inflation will be bad news for bonds as yields continue to rise at
least until May. They have little or no chance of declining between now
and then.
What
can cause a stronger market in the coming months, in spite of rising short-term
and long-term interest rates? In the September 27, 1999 issue of The Peter
Dag Portfolio Strategy and Management we told you the markets love crises.
And the Y2K issue is a crisis in the making.
Times
of crisis are good for stocks. We told you so, quite correctly we might
add, when the Asian debacle erupted in 1997 and when Brazil had the crisis
du jour last fall. The reason is that when a crisis looms on the horizon
the Fed does what everybody expects them to do: pump liquidity in the banking
system. This liquidity is the lifeblood of the market.
The
Y2K issue has the features of a crisis to be avoided at all costs. Spreads
between market driven short-term interest rates and Treasury bills have
soared exactly to the levels they were during the Brazilian crisis. Furthermore,
the fact that some monetary aggregates (M1 and M2) are accelerating suggests
that the Fed is doing what it is expected to do ahead of a potential problem
such as the Y2k inject liquidity in the banking system.
In
the meantime all our tactical indicators continue to remain in ìsellî
territory, suggesting this rally may not have lasting power, but it is too
early to call. Stay tuned.
Stocks: favorable seasonality ahead
The
Dow jumped after finding support close to the 1200 level with the technical
picture improving very rapidly.
The
most important development is that trading volume on the NYSE expanded strongly
from below 800 million shares per day to above one billion shares. Several
times we noted trading volume had to move above 800 million shares per day
for the market to go higher. It did and the market rallied.
Furthermore
the market was in very oversold conditions. For instance, the number of
stocks above their 10 and 30 week moving averages (Source: Investors
Intelligence) was well below 30.
The
other favorable technical development is the strength of the utility stocks
and of the transportation average. Their action suggests there is important
participation from these two crucial groups.
Also,
we have entered the very favorable seasonal period for stocks going from
the end of October to the end of May.
When
you add up what has happened solid support levels, strong volume, an oversold
market and strength in the utility and transportation averages, favorable
seasonality the odds favor a continuation of this rally.
The
problem is that our tactical indicators are still far from giving a buy
signal. They still say be cautious. Time will tell.
The
fundamental picture remains solidly bearish. The economy is strong. The
outcome is still higher short-term interest rates (see below) and a bearish
environment for stocks.
Short-term interest rates: higher
Market-driven
short-term interest rates continue to move gradually higher. They were 4.71%
in January and moved steadily up to 6.02% a few days ago. In the meantime
the rate on 13-week Treasury bills did not rise as rapidly, moving up from
4.40% in January to the recent 4.50%.
The
outcome is that the spread between the two interest rates has soared to
the same levels as last fall, when the Brazilian crisis was causing concern
for the financial markets. Why is the spread so high? The answer is: risk.
A
simple explanation of why the spread is so high is that money has been flowing
toward safe assets such as Treasury bills rather than riskier corporate
paper. The other reason could be that the Fed, which has direct control
of the near term on the rate of Treasury bills, is trying to keep interest
rates down because of the liquidity risk of Y2K. If this interpretation
is correct, this is good news for the stock market, because the only way
for the Fed to keep down interest rates is to inject more liquidity into
the system.
The
strength of M1 and M2 could be a sign that this is exactly what is happening.
And, of course, this is good news for stocks.
Bond Yields: Higher
Wall
Street believes the economy is slowing down, inflation is low and stable,
and yields have no place to go but down. It sounds like an ideal scenario,
but it is hard to believe. Let me explain.
Inflation
is rising and is already close to 4%. Wall Street thinks that 2% is the
current level. Let's look at the data. The employment cost index (the reason
for much euphoria) is up 4.0% in the past six months. The consumer price
index has been rising steadily since the low point of 1.5% reached last
year. Consumer prices are now up 2.6% year-over-year and 4.2% in the past
three months.
Wages
are accelerating again, up 3.88% in the past 12 months. Prices of new homes,
which were rising at a 4-5% pace in the past few years, shot up 7.8%. The
latest report of the purchasing managers shows a sharp rise in the number
of agents paying higher prices.
Finally,
a model based on the growth of monetary aggregates suggests that inflation
will rise to at least 4%, according to the Federal Reserve Bank of St. Louis..
The model is based on the fact that strong growth in money supply stimulates
demand enough to place upward pressure on prices.
The
point is inflation is certainly not under control as Wall Street likes to
believe. Most prices are rising at or above a 4% pace. Inflation has been
rising steadily since the summer of last year in perfect step with the business
cycle.
The
strong business activity of the next several months will continue to place
upward pressure on consumer prices. Inflation will peak when the economy
displays considerable weakness. Meanwhile inflation and bond yields are
heading up.
Another
negative factor for yields is that we are entering their unfavorable seasonal
period, which will last several months beginning at the end of November.
The
good news is twofold. Real short-term interest rates are high enough to
keep inflation within the 4-5% range, and real bond yields are high, making
the price of borrowing very expensive after inflation. For this reason we
are expecting yields to show a modest rise to about 7%.
The Economy: Soft News
Most
of the news released in the past few weeks reflected a softer economy.
In
the third quarter the economy grew at a solid 4.8% pace and the National
Association of Purchasing Managers reported a strong manufacturing sector
in October.
However,
the construction sector weakened further as a result of the sharp rise in
long-term interest rates. New and existing home sales sagged while housing
starts and building permits continued to decline sharply.
The
help wanted index remains in a downtrend, pointing to weaker employment
reports in the coming months. It is no coincidence that consumer sentiment
declined. However, consumers are still feeling very good about the future.
This guarantees robust retail sales in the coming months. Unemployment claims
declined and are at low levels, suggesting continued strong economy and
a tight labor market.
Durable
goods orders fell, but remain in a solid uptrend. Growth in most monetary
aggregates (M3 and MZM) continues to decline. Two major factors are already
at work and they both will cause the economy to slow down in 2000: the construction
sector and the growth of credit, that is the money supply. The decline in
the help wanted index suggests the economy is already gradually downshifting.
The
business cycle, as we mentioned in previous reports, is moving slowly from
a period of very strong growth to a period of slightly slower growth. However,
economic strength will remain solid enough to place upward pressure on interest
rates and inflation. We are still a long way from the times when growth
is so slow to justify lower interest rates and lower inflation.
Editor's
Note: George Dagnino is editor
of The Peter Dag Portfolio Strategy and Management, investment
newsletter which provides in-depth analysis of the financial markets, 65
Lakefront Dr., Akron, OH 44319, 1 year, 24 issues, $195. Peter Dag &
Associates uses proprietary economic and market indicators to measure risk
and manage money for its clients. For more details on their strategic money
management approach call 1-800-833-2782 or (330) 644-2782. Visit the Web
site at peterdag.com.
