June 27, 2005
WE'RE ALL SWISS NOW
Forget the Fed. America's saviour awaits in another Paris Air Show.
It was in gay Paree that the appetite for aeronautics snatched the U.S. durable goods orders report for May from the jaws of defeat. As the Big Picture's Barry Ritholtz observed, durable goods exploded upward by 5.5% last month, although Boeing's sales of civilian aircraft orders drove "virtually all" of the increase. Indeed, after you take out transportation orders, durable goods for May posted a –0.2% loss.
Boeing sales aside, economic weakness promises to be a topical subject this week. Translated: worries about inflation are out, and bidding up bond prices is in (as if they were ever really out). International Strategy & Investment Group's Nancy Lazar helped set the tone in an interview in the new Barron's (subscription required) when she opined that the global economy's growth is slowing. "But I think the slowdown in the economy is good news because there were some inflationary pressures starting to build up in the system." Does this suggest a recession? No, she offers. "I don't think we have the ingredients for a recession. There was an inflation scare that is fading pretty quickly -- not disappearing but fading pretty quickly. The slowdown in the economy further increases the odds that inflation probably slows a little bit."
A similarly upbeat view of inflation's reportedly receding momentum comes in the newly published Annual Report from the Bank for International Settlements:
The relative stability of inflation rates in 2004 is particularly striking when set against past periods of rising oil prices. While the increase in oil prices itself was small compared with the past two episodes, that in commodity prices as a whole is roughly equivalent. Despite the sharp depreciation of the dollar, which should have added to upward pressures, import price inflation in the United States has remained surprisingly contained. The effect on consumer prices is almost negligible. Negligible, BIS continues, because of several factors that have kept inflation low and stable:
· One is increased efficiency among developed economies, which manifests itself as lower oil imports relative to GDP. "Oil accounts for a smaller portion of imports than two decades ago as energy consumption per unit of GDP has declined," the report notes.
· Deregulation and technological advances have heightened competition and made raising prices tougher. "The steadily growing import penetration from emerging market countries such as China illustrates this effect."
· Wage pressures have remained muted, thanks to globalization. "Many observers believe that the widespread relocation of production, the outsourcing of some services and the increased mobility of labor across borders have curtailed the bargaining power of workers and trade unions in many industrial countries."
· The evolution of inflation expectations. Thanks to two decades or so of falling/stable inflation rates in the U.S. and elsewhere, central banks enjoy a high level of credibility with the capital markets. As such, any uptick in prices is expected to be short lived.
Against this backdrop, the Federal Reserve is scheduled to meet on Thursday on the ever-popular subject of setting interest rates. The Fed funds rate currently sits at 3.0%, up from 1.0% a year ago, and Mr. Market is looking for yet another 25-basis-point hike later this week. That may be the last, say some pundits. A few even predict cutting rates will return to the Fed later this year.
The sentiment can be found over on the long-end of the interest-rate curve. The benchmark yield on the 10-year Treasury Note, roughly 3.9% at the moment, is again testing lows not seen in over a year, i.e., before the Fed embarked on its round of monetary tightening.
As the U.S. yield curve continues to flatten, and bond yields around the world soften in sympathy, the market is pricing in an economic slowdown, or worse, into debt from New York to Zurich. The central bank in the U.S. has spared no effort in pumping up the money supply in recent years. But the jury's still out on whether that liquidity will deliver any more in the way of inflationary damage. The operative question is fast becoming: has the inflation momentum of the last few years run its course?
Indeed, the 10-year Swiss government bond is yielding under 2%--more than 100 basis points the short-term Fed fund rates! Any surprises of economic growth could take the air out of the global bull market in bonds quickly, but for the moment the U.S. and other markets seem intent on following Zurich's lead. And who can argue on a Monday when oil prices rose to another all-time high above $60 a barrel? The world economy is energy efficient, relative to the past, but there are limits. If $60-plus holds, the near-term pressure on GDP will endure, and then some.
When it comes to pricing bonds, we're all Swiss now.
Posted by jp at June 27, 2005 5:23 AM