The stock market yesterday was encouraged with the upward revision in first quarter gross domestic product. So too was the bond market. Can both markets be right?
Indeed, before the Thursday revision there was a somewhat different view of the world. In particular, the first estimate of first-quarter GDP was 3.1%, a pace that sparked worries that a “soft patch” in the American economy was approaching. But the soft-patch forecast was dealt a mild setback yesterday with the first-quarter GDP revision that recalculated the economy’s growth at a higher 3.5%, according to the Bureau of Economic Analysis.
The notion that growth was a bit more robust than previously thought had the expected effect in the stock market. The S&P 500 climbed by more than one-half a percent as the Nasdaq Composite tacked on slightly more than a percent yesterday.
The stock market’s glee was no great shock. A stronger economy typically translates into stronger earnings. But why did the bond market yawn at the upward revision in GDP? That is, why the slight drop in yield yesterday in the benchmark 10-year Treasury, which closed Thursday’s session at roughly 4.08%, down every so slightly from 4.09% at the previous close—both of which are yields that are the lowest since February.
Perhaps the fixed-income set took inspiration from the fact that the GDP price index for the first quarter was revised down a bit to an annual 3.2% rate from 3.3% previously. In addition, there’s the knowledge that the unexpected narrowing of the trade deficit in March contributed to the bullish revision in GDP for the January-March period. Indeed, the slimmer trade gap was the byproduct of lesser imports, which in theory will help trim inflation’s momentum in the U.S. a bit.
On the other hand, wage and salary income advanced somewhat in the latest GDP revision. For one wing of the dismal science, that’s a warning flag for inflationary pressures. The Wall Street Journal (subscription required) today quotes David Greenlaw, an economist with Morgan Stanley, as saying that the uptick in wages and salaries may portend higher inflation down the road. Greenlaw notes too that he expects the Federal Reserve to be poring over the revised GDP numbers in the days ahead to gauge whether labor cost increases are here to stay, and if that raises the inflation threat.
But maybe some in the bond market are expecting support for buying fixed-income securities anew when the Institute for Supply Management (ISM) releases on June 1 its manufacturing index update for May. Why? Paul McCulley, managing director of the giant bond shop Pimco, explains in his May Fed Focus essay, noting that “In the Greenspan era, the Fed never keeps tightening once the ISM Index drops below 50.
The ISM Index “is the single best indicator of cyclical regularity in the manufacturing sector, itself driven by cyclically regular swings in the pace of inventory accumulation, which is the primary impulse to cyclical regularity in commodity prices (and the so-called PPI pipeline),” McCulley continues. At present, the ISM Index stands at 53.3%. Readings above 50 are said to be a sign that the manufacturing sector’s expanding; below 50 suggests economic contraction. Although the ISM measure was in growth territory as of April, as it’s been since June 2003, the trend of late is decidedly down. Indeed, the ISM Index peaked in the current cycle at 62.8 back in January 2004, and it’s been downhill ever since.
Will it dip below 50? It’s all but certain in the near term, predicts McCulley. If history’s a guide, a below-50 reading will coincide with an end to the Fed’s rate hikes, McCulley suggests. Timing is unknown, of course. But between now and the June 30 meeting of the Federal Open Market Committee there is ample opportunity for dreaming, speculating and otherwise bidding up the price of fixed-income securities.
McCulley’s take on the future is music to the bond market’s ears. So too is this morning’s news from the government that the inflation-adjusted price index for personal consumption expenditures rose a modest 0.2% in April, down from 0.4% the month before despite the fact that personal income rose a robust 0.7%.
The stars arguably are aligning in the bond market’s favor. As a bonus, the stock market doesn’t have a problem with the data either. When everyone’s bullish, there’s no place for bears. That by itself suggests opportunity, or perhaps a warning, albeit one that only a contrarians can embrace.