Is the Economy Headed for a Fall?

Rallying bonds, weaker housing, cooling inflation. Analysts, however, disagree on whether it's a recipe for recession blues

by Peter Coy

Forget the Democrats and the Republicans.

As heated as the political races have become with a month to go before the midterm elections, the most hotly contested debate these days may be between the economic bulls and bears. Those convinced that the U.S. economy is humming along smoothly include stock market investors, who have pushed major equities near their all-time high (see BusinessWeek.com, 9/27/06, "Decoding the Dow's Big Run"), and the Federal Reserve under Chairman Ben Bernanke, which remains poised to boost interest rates if necessary to cool inflation.

On the other side, however, are bond investors. The bond market has been rallying in recent weeks—which it typically does when it expects the economy to cool off. In fact, fixed-income investors are predicting that rate cuts are just over the horizon, a move that may be necessary for the Fed to stave off recession. "It is highly doubtful that both asset classes can be getting the story right," wrote David Rosenberg, chief North American economist for Merrill Lynch (MER) in his Oct. 2 morning call notes. "We have a sneaking suspicion that the bondies have the story right."

The latest news supporting the bears' case came on Oct. 2, when the Institute for Supply Management reported weaker than expected manufacturing activity last month. The ISM manufacturing index dropped to 52.9% in September, from 54.5% in August. That pushed up two-year, five-year, and 10-year notes. Investors can now earn higher yields on six-month bills than on two-year notes, indicating an expectation for interest rates to fall.

CONTRADICTORY REPORTS.

Optimists say that the bond market is rallying because it expects inflation to fall, not because it expects economic growth to wither. But Rosenberg says that according to his reading, diminished inflation expectations explain only one-third of the rally in the 10-year Treasury note since the Federal Reserve went on hold with its interest rate hikes this year. The remainder of the rally, says Rosenberg, is attributable to a decline in so-called real interest rates. Real rates fall when the economy's growth rate declines.

The fall in gasoline prices is welcome, Rosenberg says, but it can't compensate for the steep downturn in the housing market. That threatens to undermine consumer spending and has hammered the stocks of homebuilders such as KB Homes (KBH), DR Horton (DRI), and Lennar (LEN) (see BusinessWeek.com, 9/7/06, "Builders Brace for a Housing Downturn"). What's more, Rosenberg says, the fall in oil prices may be an indication that smart traders are expecting a steep decline in oil demand from slower economic growth. Rosenberg also notes that the Conference Board's index of leading economic indicators—a widely watched weather vane—has fallen for four of the past five months.

There are plenty of experts who see very different prospects for the U.S. economy, including Robert DiClemente, head of U.S. economic and market analysis at Citigroup Global Markets. "Sitting comfortably" is the headline on his Sept. 29 analysis. Yes, says DiClemente, the expansion is moderating. But he sees that as a good thing—it removes inflationary pressures, allowing the Fed to stop raising interest rates and keeping growth intact.

ONE ECONOMIST'S GUESS.

Citigroup (C) is predicting below-trend growth to last only into the first part of 2007, mainly because of weakness in housing and auto manufacturing. Housing already shows early signs of correcting itself, says DiClemente, with construction having fallen so much that inventories of unsold new homes should begin to work themselves out "barring further deterioration in sales."

"In our judgment," writes DiClemente, "growth pessimists have oversold the potential for declines in housing wealth but also have underestimated the broader health and sustainability of the current upturn." He notes that consumer spending is showing "continued resilience."

Wall Street economists get paid to help investors make money by calling the turns in the economy correctly. That means they tend to call them as they see them, regardless of which political party they make look good or bad. You can learn more from their dissection of the numbers than you can from the Sunday morning talk shows. Even when they disagree—or, maybe, especially when they disagree.

Coy is BusinessWeek's Economics Editor.