There was enough weakness in yesterday’s report on existing home sales for December to keep pessimism alive about the economic outlook for 2007. But the bond market wasn’t waiting around for definitive signs and instead ran for cover. (Update: Since we posted this morning, new home sales numbers for December were released, reporting a gain of 4.8%. As a result, new home sales rose last month to their highest since April, offering an optimistic offset to yesterday’s less-inspiring news on existing home sales.)
The selling yesterday pushed the yield on the 10-year Treasury up sharply, closing at around 4.87%, the highest since last August. The notion that the economy will stay fairly robust has apparently taken root in the hearts and minds of bond traders and planted the fear that rates may rise before they fall. For the fixed-income set, that’s reason enough to become defensive.
But while the trading floors focused on the 10-year Note seem to have blinked in deference to the growth-will-be-stronger-than-expected crowd, there are no signs of capitulation (yet) over in Fed funds futures pits. Looking at the array of contracts expiring in coming months, one theme is clear: the popular bet at the moment is a Fed that will hold rates steady at 5.25% for the foreseeable future. That’s been the bet for some time now, based on recent history in Fed funds trading, and it appears to be the consensus view for pricing Fed funds through the summer.

As we reported earlier this week, there are a number of seers who forecast that 2007 will be a decent, if not exactly impressive year for general economic expansion after all. One optimist we heard speak on Tuesday said as much, and we detailed his thoughts here.
But at least one dismal scientist is warning otherwise by saying that economic risk still lurks and that this is no time for complacency. Nouriel Roubini, who’s been attending the talkfest a.k.a. the World Economic Forum in Davos, Switzerland, advises that he continues to see trouble ahead. On his blog, Roubini wrote on Wednesday that he was on an economics panel at Davos and he alone “expressed some concerns about a U.S. hard landing that could take the form of a growth recession or an outright recession.” The head of Roubini Global Economics also outlined three potential risks that could derail the soft-landing scenario that many now expect for the U.S. economy:
1. A continued housing recession that spills over into other sectors of the economy.
2. the delayed effects of the Fed Funds increase and the beginning of a credit crunch in the mortgage market…
3. Oil prices that remain high, albeit lower than last year’s peak
The bottom line, Roubini wrote: “There are still meaningful risks of an outright recession this year.”
Roubini may be in the minority on the economic outlook, but there’s enough conflicting evidence (and more to come?) that will keep this debate alive in coming weeks and perhaps months. As we’ve written before, ours is a period of transition, which is a clever way of saying that the future’s unclear, or at least less clear than it has been in the last couple of years. Given this tender climate, one or two surprising data points could change perceptions far and wide. For the moment, the consensus seems to have swung around to the idea that the economy will continue to bubble. For what it’s worth, that’s our view. But like everyone else, we reserve the right to adjust our outlook. Heck, we’ll admit the obvious right here and now and say that we don’t really know what’s coming, even if we occasionally adopt an attitude in our prose that suggests otherwise.
Perhaps the only comfort is that when it comes to strategic-minded portfolio design, the performance numbers tell us most of what we need to know. With that in mind, we’ll continue to take profits in asset classes the longer they run and redeploy capital into asset classes that have suffered relatively or absolutely. Such a strategy won’t deliver stellar gains in the short term, but it’s the only game in town if you want to impress in the long haul.