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Wednesday, July 26, 2006

Bullish Case on Bonds

Some commentary by Hoisington Investment Management, who are bullish on bonds. They feel that even if the Fed tightens a couple more times, we have seen the peak in bond yields. They feel that falling money supply growth and wage costs indicate that inflation is contained, and headline inflation numbers are actually lagging. They feel that the economy is already slowing down and at risk of recession due to the Leading Economic Index (LEI) data and due to the yield curve inversion. Their commentary supports our view that the Fed is at or close to the peak of interest rate hikes.


First Half Sell-off

Treasury yields rose across the board in the first six months of 2006. Two, five, ten and thirty year Treasuries posted results of 0.7%, -2.0%, -3.9%, and -7.6% respectively. The Federal funds rate, adjusted higher four times in 25 basis point increments during the first half of the year, was the proximate cause for the sell-off. It is our expectation that interest rates will move noticeably lower in the second half of 2006 in response to a rapidly deteriorating U.S. economic environment. The cumulative impact of a tightening Fed policy, rising interest rates, elevated energy costs and modest job growth, in concert with the structural problems of an over-leveraged consumer sector and international wage competition, has created the risk of a sharp and/or elongated slump in economic activity.

Slowdown in Progress

The question of whether an economic slowdown will occur is moot since it has arrived. Coincident indicators of economic activity, such as job growth, are decelerating rapidly. Over the past three months, private sector job gains have averaged a paltry 86,000 per month, some 44% less than the average monthly increase in 2005. Real consumer spending, which accounts for nearly 70% of total GDP, is slated to expand less than 2% in the second quarter, compared with the 3.5% gain in 2005. Construction spending (residential, commercial, industrial and public) is also on track to display no growth in the second quarter. Thus, 80% of GDP is presently expanding at only half the rate registered last year.

The sharp loss of momentum in this expansion has been well signaled by the leading economic indicators. First, the Leading Economic Index (LEI), as computed by the Conference Board, has now contracted over the past six months (Chart 1). This is a significant development since a decline of that duration has only occurred thirteen times since the end of the Korean War. Outright recessions followed nine of those episodes, and severe slowdowns were registered in the other four episodes. It is important for investors to note that short and long term interest rates fell in the aftermath of all of the previous thirteen slumps in the LEI.

An alternative leading index can be constructed by calculating the ratio of the Conference Board's composite index of coincident economic indicators divided by its composite of lagging indicators. In a late stage expansion, the rate of increase in the coincident composite should be rising less than that of the lagging composite and the ratio should be falling, exactly like the present situation.

This alternative index has the disadvantage of being far more volatile than the LEI, eliminating the ability to obtain useful knowledge from changes of a year or less. Notably, the ratio has declined over both the latest 18 and 24 month intervals. The 18 month change in the ratio has been consistently negative for a year, while that for the 24 month change has been in the red since October 2005. Since the Korean War, fourteen instances have occurred when the ratio declined a minimum of 18 months (Chart 2). Nine recessions, four severe slowdowns, and one false signal followed. Thus, the alternative leading index indicates that downside risks to the economy are large, but unlike the LEI it indicates that the evolution of the eventual outcome is at a more advanced stage.

Yield Curve Inversion

In late June, the Federal funds rate rose above the ten year Treasury note yield. This was a result of the Fed forcing the Fed funds rate higher while the ten year did not follow suit. Sometimes this is referred to as a "frontdoor" inversion. According to Expectations Theory, market investors, on average, held the view that the economy was already slowing, creating the likelihood of interest rate declines at a later date, and this fact was more important to investors than the Fed's hike in the Federal funds rate.

Over the prior 55 years, the Federal funds rate has exceeded the ten year note yield only eight times. Six of the inversions were followed by recessions. The 1966 inversion was followed by a severe slowdown, but a recession was avoided because of substantial increases in Vietnam War military spending, Lyndon Johnson's Great Society Welfare program, and a dramatic and rapid easing in Fed monetary policy under the leadership of William McChesney Martin. A 1998 inversion, unlike the earlier seven, was of the "backdoor" variety caused by a drop in ten year yields, not a rise in the Federal funds rate. If we exclude the "backdoor" inversion of 1998 since it was of a different type, recessions occurred after six of the seven previous "frontdoor" inversions.

Monetary Indicators

Today's yield curve inversion gains more significance when it is corroborated by key monetary indicators. For instance, real M2, one of the most reliable of all leading indicators, has declined from an 9% growth rate in December of 2001 to a miniscule 1.1% expansion in the twelve months ending June, 2006. Further, total reserves of the banking system have fallen over the past twelve months by .5%. Since 1945, the growth in total reserves slowed prior to all ten recessions.

Avoiding a Hard Landing

Yield curve inversions and extended declines in the leading indicators portend a recession, but they do not tell when it might occur. The historical record suggests that a recession could occur by year end, although the lead time could be longer. From the initial decline in the LEI to the start of the nine post Korean War recessions that followed, an average of 9.6 months elapsed (Table 1). The shortest lead time was four months and the longest 19 months. However, the lead time for six of the nine recessions was clustered between four and eight months. The reason that lead times vary is that the initial conditions are never the same. The initial conditions that could shorten those lags currently are the record level of household sector debt and this decade's unprecedented housing boom. But, there is an initial condition - exploding growth in China and India - that could extend the lags.
The possibilities become clearer if we examine the historical instances when the yield curve inverted and the LEI registered a six month decline.

There are only seven such instances in this half century, and recessions followed all but one. Once this double coincidence occurred, the average lead time to recession was 9.3 months (Table 2). Of the ensuing recessions, the lead times for four were clustered between five and eight months, while the other two were 14 and 16 months. It may be too late for the Fed to avoid a recession.

In the past, when the economy was under stress similar to today's, outside shocks, which could not have been anticipated, frequently occurred. In 1970 and 1974, respectively, the Penn Central Railroad and Franklin National Bank of New York failed. In the summer of 1982, Drysdale Government Securities and Lombard Wall failed, causing the U.S. government securities market to temporarily freeze. In the summer of 1990 Iraq invaded Kuwait, and 9/11/2001 is well remembered. Presently, the economy is susceptible to an outside shock that could serve as a catalyst for negative economic forces at work.

Absence of a Money/Price/Wage Spiral

Since the early 1990s, disinflation - a general decline in inflation, has characterized the United States. Presently, the sharp rise in energy costs has caused a slight, but far from serious interruption of that downward trend. In May, the year over year rise in the core Personal Consumption Expenditure (PCE) deflator was 2.1%, or slightly above the 1%-2% range that Federal Reserve Chairman Ben Bernanke has stated to be price stability. The present level is at the midpoint of the 2% and 2.2% increases in 2005 and 2004, respectively.

Although a further pass-through of energy costs is likely to push the year over year rise upward over the next several months, such a development should not be taken as a sign that inflation is moving higher. Multi-year inflations take the character of what may be termed a money/price/wage spiral. This analysis is consistent with a great deal of economic theory including Macroeconomics, Fourth Edition by Andrew Abel and Ben Bernanke. Here the authors state (page 292) that money (M2) growth is procyclical and leading, while inflation is procyclical and lags the business cycle.

To have a money/price/wage spiral develop and become entrenched in the economy, money growth must accelerate, be sustained, and lead to a speed-up of price increases across the board. Then the widespread rise in inflation must lead to faster wage increases that are validated by a further acceleration in money growth and inflation.

This happened in the 1960s and 1970s when M2 growth was the highest for any two consecutive decades. M2 growth averaged 7% in the 1960s, and then accelerated to almost 10% in the 1970s. This was the fastest acceleration for any decade other than those containing World Wars I and II. In the 1970s the core PCE deflator increased by as much as 8% per annum, more than triple the average 135 year inflation rate. Wage costs accelerated steadily in those years. The Employment Cost Index registered its all time high of nearly 11% in 1980 (Chart 3).

The current situation is extremely different. In the past two years, M2 growth has averaged just 4.2% per annum, a far cry from the pattern in the 1960s and 1970s, and well below the 6.6% average increase in M2 since 1900. The Employment Cost Index was up just 2.6% in the latest four quarters, a record low increase. Hence, money growth is decelerating and so are wage costs. This is more likely to lead eventually to a downward money/price/wage spiral rather than to an upward one.

Lower Bond Yields Ahead

Long term interest rates rose in the second quarter, following increases in the first quarter, as the Fed pushed the Federal funds rate to 5.25%. Investors may be worried that further tightening is to come, but any such actions would serve to limit money and credit growth, while increasing the negative slope in the yield curve. Any additional monetary stringency would risk a downward money/price/wage spiral.

In 1990 and 2000, the Fed failed to properly account for the lags in monetary policy and carried restraint too far. If the Fed targets inflation, a lagging indicator, with changes in the money supply, a leading indicator, they will tend to overshoot regardless of whether they are tightening or easing. Now the immediate economic risk is for overshooting on the downside. A hopeful sign is that Donald Kohn, the Fed's Vice Chairman, said that they are "aware of those risks."

With the economy already in a slowdown, recession risks rising, and inflation contained, we view the bond market setback in the first half of this year as temporary. Should a further hike in the Federal funds rate be initiated, it should not be viewed unfavorably by long term investors. This would only insure that the present economic slowdown would deteriorate into recession, causing all yields to decline precipitously.


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