BONDHOLDERS HAVE LITTLE TO FEAR FROM A STRONGER ECONOMY
The rally in the bond market has come a long way. Since the autumn of 1991, the rate on 30-year Treasury bonds plummeted from more than 9% to less than 6%. But in recent weeks, trips below that 6% mark have not lasted very long. Is the party over?
Probably, for now. Terrified as it is of a strong economy, the bond market has taken a look at some of the snappy data in recent weeks and decided to tone down its euphoria (chart). Bondholders fear that an acceleration of growth could rekindle inflation, which would erode future returns. So bond prices fall, and yields rise.
To be sure, the U.S. economy is taking on a healthier glow. Despite their glum attitudes, consumers led third-quarter growth in real gross domestic product with a strong performance, and they headed into the fourth quarter with the same buying fervor. There are even signs that the sluggish factory sector is shifting into a higher gear, especially as Detroit revs up production amid surprisingly strong car sales.
But resistance at 6% does not mean that yields are about to spike up. Even if economic growth is picking up in the second half, to an annual rate of 3% or better, that's no cause for inflation worries. It would take more than a year for growth at that pace to push the jobless rate below 6%, and only then would labor-market conditions be tight enough to fuel the wage-price spiral. At the same time, stiff competition--both domestic and foreign--will continue to limit pricing power.
In fact, economic fundamentals justify long-term rates of 5.5%. Historically, yields have averaged about 2.5 percentage points above the inflation rate--expected to be about 3% this year and next. This kind of reasoning has played an increasingly important role in the bond market this year, now that the budget deficit no longer casts such an ominous shadow over market players.
Of course, no one has ever accused the bond market of listening to reason. Right now, what the market sees is a better-looking economy with consumers supplying a lot of the vigor. That's especially true in two key areas that traditionally provide broad business impact, housing and autos.
The lowest mortage rates in a quarter-century are drawing potential homebuyers off the sidelines and into the market. Sales of existing homes rose 2.6% in September, to an annual rate of 3.91 million, reported the National Association of Realtors. It was the fifth increase in the past six months. And homebuying is generating a spurt in demand for a host of home-related goods.
The September rise was significant in three respects. The NAR said that first-time homebuyers posted an impressive turnout, a sign of broad strength. Also, sales in the West even picked up, suggesting that the depressed California market is showing some life. Finally, the gain pushed the third-quarter average of sales to 3.86 million, only a shade below the 13-year high of 3.87, hit in the fourth quarter of last year.
In addition to homes, people are buying cars at a rapid clip. Mid-October sales of domestically made cars and light trucks soared to an annual rate of 13.5 million, far above the 11.5-million pace averaged during the three previous 10-day periods. Car sales alone scored a 7.8-million pace, the best 10-day showing in years. That strength lends credence to the notion that car buying previously had been held back by a lack of inventory.
So instead of depressing overall retail sales, as they did in September, car sales should fuel a strong gain in the October report, especially since demand elsewhere also looks solid. Sales at retail and discount stores in the first three weeks of October were up 0.8% from September, according to the latest Johnson Redbook Report.
Moreover, Detroit is now in the process of remedying its inventory shortfall. Carmakers are lifting their fourth-quarter production sharply. Based on current output schedules, economists estimate that auto production by itself will add some 1.5-to-2 percentage points to growth in fourth-quarter real GDP. Manufacturing generally will feel the benefits, as business picks up in the industries dependent on Motor City.
Already, factory orders are showing new bounce headed into the final quarter (chart). Orders received by manufacturers of durable goods in September rose for the second consecutive month, lifting bookings to the highest level since February. The broad 0.7% increase was better than most analysts had expected, and it followed a 2.6% jump in August, the first back-to-back increase in a year.
The September order gain was even better than it looked. Bookings for commercial aircraft, a small sector with a big impact, fell in September. Excluding that drop, the monthly advance was much stronger.
One growing paradox in the outlook, however, is the apparent decoupling of consumers' confidence and their spending behavior. At the same time households are laying out big bucks, they report declining optimism about the future.
In October, the Conference Board's index of consumer confidence fell to 59.4, reversing the September increase to 63.8 (chart). A drop in the expectations component accounted for the entire decline, but that might more reflect households' views of the direction of the Clinton Administration's economic and foreign policy than the state of their checkbooks. Consumers' assessment of their present economic situation held at the September level, which was the highest in 2 1/2 years.
Still, the bond market pays more attention to what consumers do, not how they feel. What bond players will be grappling with in coming weeks is whether the pickup in consumer spending--and in economic growth, generally--will rekindle inflation.
For now, the word from the labor markets--where pressure on prices tends to originate in recoveries--is: Don't worry so much. The Labor Dept.'s employment-cost index, a broad gauge of labor-cost pressures from wages, salaries, and benefits, rose only 0.8% during the third quarter. That gain lifted labor costs 3.6% above a year ago. Since the jobless rate peaked in the second quarter of 1992, annual growth in the ECI has stopped slowing, but there has been essentially no acceleration.
Benefits still are the primary fuel under labor costs. Annual wage growth picked up slightly last quarter, to 3%, while fringes posted growth of 4.9% (chart). However, unlike wage growth, the pace of benefits continues to slow. They had risen 5.3% in the previous year and 6% the year before that. Benefits will continue to slow due to efforts to reduce health-care costs.
In addition, even given the settlement between General Motors Corp. and the United Auto Workers, unions show little success in pushing up labor costs. Major collective-bargaining settlements continue to result in wage increases over the life of the contract that are smaller than the agreements they replace. In the third quarter, wage settlements averaged a 1.6% rise, down from 2.9% the last time the same parties bargained.
Perhaps the most important reason labor costs are unlikely to create price pressures anytime soon is the restraint that faster productivity growth is placing on the pace of unit-labor costs, which typically act as a floor under price growth.
If employment costs are rising at a 3.5% pace, with productivity growing at a 1.5% clip, then unit-labor costs are increasing at only about 2%. Under those circumstances, businesses feel no pressure to raise prices, since 3% inflation allows a healthy margin for profits.
Of course, reasoning like this will never convince a skittish bond market. So, long rates are likely to drift up on signs of a more vigorous economy. But just in case you missed the opportunity to refinance your mortgage at the rock-bottom low point in rates, economic fundamentals say you might still get another chance later on.JAMES C. COOPER AND KATHLEEN MADIGAN