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JUNE 27, 2005
Rumbling Over Rates Bond buyers are fighting the Fed. At stake: Mortgage costs and corporate finance Resilience has been the hallmark of this 3 1/2-year business upswing, and it is on display once again in 2005. The economy has absorbed the shock from surging energy prices and eight interest-rate hikes by the Federal Reserve with barely a dent. This expansion appears set to roll on at a healthy clip into 2006. That's the general view of the 31 economic forecasters surveyed by BusinessWeek. On average, they expect the U.S. economy to grow by 3.4% from the second quarter of 2005 to mid-2006. They look for inflation to slide, mainly thanks to an expected decline in crude oil prices from a peak of $57 per barrel this past March to $46 this time next year. The forecasters also project that the Fed will keep lifting its federal funds rate, although not at the one-hike-per-meeting pace of the past year, which has pushed the rate up by two full percentage points, to 3%. Instead, they look for the Fed's target rate to rise about one more point, to between 4% and 41/4%, by the second quarter of 2006. By then, they expect the yield on 10-year Treasury bonds to drift up to 5%. That's a surprising revision from BusinessWeek's last poll in December, 2004, when forecasters thought the 10-year bond yield would already be at 4.75%, not its current rate of about 4%. That miscalculation highlights this year's most intriguing puzzle for forecasters as well as Fed officials: the unprecedented disparity between rising short-term rates set by the Fed and the failure of long-term rates set by the bond market to follow along. That bond yields have fallen since the Fed began to hike rates last June has many economists perplexed. "The 10-year note at 4% or less makes no sense," says Nicholas S. Perna of Perna Associates. "It should carry the warning, 'Caution: This product can be hazardous to your wealth."' Depending on who blinks first, this stare-down between the bond market and the Fed will have crucial implications for the economic outlook in coming months. If the Fed stops raising rates, low bond yields would continue to fuel home prices, making a dangerous situation worse. But if the bond market caves in, long-term interest rates could spike up quickly, with negative consequences for mortgage rates, corporate finance, and any overleveraged hedge funds. The disparity is unusual because fears of an oil-related blow to economic growth -- which tends to dampen bond yields -- are already fading. "The soft spot is history," says Maury Harris at UBS Securities. (UBS ) If there ever was one. The expectation was that consumers would take a hit from costlier energy just as they did in 2004, but households never flinched. With consumers steadfast, businesses are set to continue expanding. "I expect capital spending to be the strongest part of the economy," says Richard D. Rippe at Prudential Equity Group LLC. (PRU ) MANUFACTURING WEAKNESS Why have consumers and businesses been so resolute? Cold, hard cash. Thanks to stronger job markets, first-quarter wages and salaries, after accounting for inflation, grew 5% from a year ago, the strongest pace in four years. First-quarter data also show household wealth is up to a record $48.8 trillion, while corporate balance sheets have never been healthier, with the ratio of debt to net worth at a 15-year low. Corporate borrowing conditions in the credit markets and at banks are easy. And for the first time, cash flow has exceeded capital spending for two years running. Instead of an energy-related drop-off in demand, the economy's main sore spot is manufacturing. That softness has been less related to energy prices than to a modest adjustment of inventories that had built up too rapidly earlier this year. Now that the adjustment is about finished, factory activity is expected to pick up. In fact, some economists believe the soft spot idea was overplayed because so much of the data are geared toward manufacturing. "This sector is only 15% of the economy, and it garners about half of the press attention," says Ethan Harris at Lehman Brothers Inc (LEH ). So is the economy's path free of debris? Not quite. Most of the uncertainties that weighed on investors' decisions at the end of 2004 remain heavy today. Although risks from oil and the dollar have eased, they could still whipsaw markets in the coming year. Slowdowns in Europe and China may curb export growth, limiting the rebound expected in U.S. manufacturing. Also, the froth in the housing market keeps bubbling up, raising fears that a drop in home prices could hammer consumer spending. Plus, new cost pressures on businesses are building in the labor markets, a factor that could have a direct impact on investors' portfolios. "Rising labor costs will pose some threat to both inflation and profit margins," says Lynn Reaser at Bank of America's (BAC ) Investment Strategies Group. The direction of inflation -- and its implication for interest rates -- is uppermost in economists' minds. While lower oil prices are expected to push overall inflation down, core inflation, minus energy and food, is expected to drift up. Richard Berner at Morgan Stanley (MWD ) believes the spring easing in core inflation should be viewed as temporary. "The recent acceleration in labor costs is a yellow flag for inflation watchers," he says. A recent survey by PricewaterhouseCoopers shows that businesses are raising prices to cover higher costs. "Once investors understand that if a firm can raise prices under the guise of higher energy costs, they have enough pricing power to raise prices for any reason," says Joel L. Naroff of Naroff Economic Advisors Inc. How the inflation scenario plays out could decide the battle between the Fed and the bond market. Bond investors seem to believe that economic growth will be slow enough to keep inflation under control, and that the Fed is about ready to stop hiking rates. But judging by Fed Chairman Alan Greenspan's congressional testimony on June 9, it doesn't sound as if the Fed is ready to stop lifting rates anytime soon. He said a serious economic slowdown is unlikely, and he offered some mild caution about the inflationary potential in the recent increase in labor costs. The economists in our survey are betting the Fed will prevail. "'Don't fight the Fed' is time-tested wisdom," says Neal Soss of Credit Suisse First Boston (CSR ). Investors should keep that in mind as they make their portfolio decisions in the coming months.  By James C. Cooper and Kathleen Madigan
BW MALL
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