Fixed Income? Part I.
Jarrod Wilcox, March 12, 2004

Why Worry?

Although US economic recovery in the first half of 2004 seems firmly established, two indicators of prosperity have been slow to emerge – increases in employment and increases in interest rates.  At the same time, the US dollar has been exceptionally weak.  These discomfiting facts tend to make bond investors nervous.  When will interest rates go up?  Could there be a crisis lurking?  I think there is a crisis scenario possible, the result of years of buildup of imbalances caused by globalization-induced productivity shocks in emerging market economies, and US governmental attempts to soften the shock.  I hope it won’t turn out this way, but it doesn’t hurt to be prepared.

Let’s first see what current pricing reveals about expectations.   The top row in the table shows yields to maturity for US Treasuries as of March 11, 2004, courtesy of Bloomberg.  The second row shows an estimate of the typical risk premiums embedded in the term structure that I calculated from looking at the average yield slope for a thirty year period as supplied by Professor Craig Holden of Indiana University (http://www.spreadsheetmodeling.com).  The third row gives adjusted yields net of this supposed risk premium, and the bottom row approximates a forward rate from it.

What the table indicates is that the short-term end of the curve is very flat, so flat that it doesn’t even account for a normal risk premium, and therefore may well be predicting still lower short-term rates, especially over the next 6 months, but even up through a two-year horizon.

On the other hand, after the first year, the slope is nicely upward, characteristic of expectations for either a stronger economy or increased monetary inflation. What’s going on?

Professional forecasters weigh in heavily on the side of rapid economic growth, perhaps extrapolating the trend of the past several quarters.  For example, the Congressional Budget Office forecasts growth in the gross domestic product (GDP) of 5.9% in 2004, of which only 1.1% will be due to inflation.  The Conference Board says 5.7%.  Many private forecasters are a little lower, but still estimate growth in excess of 4%.   And there is concrete evidence backing these forecasts.  The leading indicator series stemming from Geoffrey Moore’s work on business cycle are mostly up.  Capital spending is picking up, though from low levels.  And non-manufacturing activity continues positive.

At the same time, in a Presidential election year, the Executive Branch of the Federal government has been pouring on the coal.  Continued tax cuts and a huge budget deficit ($480 billion at last count for 2004, with no end in sight in future years) are doing their bit to stimulate the economy.

When these conditions are factored into conventional interest rate forecasting, the consensus is for a moderate increase in the 10-year Treasury note by year-end (the Congressional Budget Office suggests a 0.6% increase).  Many financial advisors are telling their clients to shorten up bond maturity schedules.

The Other Side of the Coin

However, it is always dangerous to accept the consensus on current pricing.  It is the surprises, not the consensus already factored in, that will move prices from current levels.  In thinking about surprises ahead, we might learn something from the surprises that have taken place over the course of the business recovery so far.

Is Job Growth Coming?

Employment is typically a lagging indicator, but this time it seems unusually slow.  Early this year, I saw forecasts of 100,000 to 200,000 jobs to be added in February.  When the report came out, the actual figure was 21,000.  And of course there is the initial White House forecast of 3 million jobs added for 2004 as a whole, which was revised downward to closer to 2 million, and which I suspect is now being privately revised downward to something much lower.

The national media has focused on the growing outsourcing of white-collar jobs to other countries – the prime example has been telephone service centers and now computer programming in India.  But the loss of blue-collar manufacturing jobs to Mexico and the Far East has been going on longer and is a good deal larger.  The same thing is going on in Germany, with the entry of Polish goods, and Japan, from less-developed countries nearby.  Today, the egregious irritant is the flood of inexpensive Chinese goods in US markets. The shock of cheaper goods and services entering the US market from emerging economies is real, and a result of globalization trends that will not soon abate. 

In theory, consumers benefit and new jobs will be created to replace those lost.  In practice, the people who lose their jobs are not necessarily those who go into the newly created jobs, and when they are, pay is usually lower, the anticipation of which slows the movement.  In other words, there are painful transitional effects that cause unemployment and underemployment.  These are likely to be long-lasting, perhaps a few years, but perhaps decades.  In either case, what if the current US economic business recovery does not translate into increased income for most employee-consumers?  The danger is that the recovery will not be self-sustaining.

Understanding Alan Greenspan

On the other hand, low-priced competition tends to keep down inflation in tradable goods and services.  If the dollar does not weaken fast enough, and if workers and prices within the US market do not move fast enough, there could even be deflation.  This would be very bad for all those people and financial structures heavily in debt, because they would have to pay back in dollars of greater economic value, precipitating bankruptcies and a liquidity crunch.

We know that the Federal Reserve under Chairman Greenspan has responded to evidence both of inflation/deflation and unemployment in its administration of short-term interest rates.  Because inflation is low, the Federal Reserve has felt free to try to stimulate economic growth to serve the body politic, which is largely sensitive to employment. The urge for stimulus became even greater as the risk emerged recently that there might be deflation.

Consequently, the first explanation for the forecaster’s mistakes were that the shock of emerging market products and services, along with, to a lesser degree, unexpected increases in productivity, were responsible for weak employment pickup.  Second, the same shock was responsible for keeping reported inflation low.  Third, the Federal Reserve endeavored to keep real interest rates low, that is, interest rates net of inflation, to try to avoid too much stress on the financial system and to help stimulate employment.  There is also the less obvious fourth phenomenon, that the resulting low interest rates helped weaken the dollar even beyond the trade deficit effect.

This weaker dollar will tend to smooth some of the pressure from foreign imports as it makes them locally more expensive.  (Unfortunately, some of the emerging economy countries, particularly China, have stubbornly kept their currencies locked to the dollar.)

The Unfortunate Side-Effects

But abnormally low short-term interest rates have had other less helpful effects.  Along with the worldwide increase in commodity prices that naturally result from increased internal use by rapidly developing economies abroad, the weakened dollar encourages more rapid US inflation of energy prices and other materials that were previously imported. The carry trade of borrowing short and lending long has encouraged leveraged financial structures that would not otherwise be sustainable, and which could be severely threatened if interest rates increase.  It has led to inflated prices, and extraordinarily low yields, for longer-term bonds.  And it has led to a great increase in consumer spending for bigger houses and bigger mortgages, as well as inflated real estate prices in general.  Finally, low interest rates help inflate the price of stocks.

Should We Prepare for A Crisis Scenario?

Investors who have been around the block are concerned with these imbalances.  Warren Buffett and Peter Bernstein have voiced doubts.  Sell-side investment strategists, particularly Stephen Roach at Morgan Stanley, but even perennial optimist Ed Yardeni at Prudential, have questioned the wisdom of continued monetary stimulus.  However, they are too tactful to tell us the worst case scenario.  Suffering no such inhibitions is Marc Faber, the independent, typically contrarian, author of the Gloom, Doom and Boom Report (www.gloomboomdoom.com).

Faber asserts that the strong US economic recovery is totally artificial.  His long-term forecast is for continued dollar decline, emerging market economic growth leading to disruption in the more advanced economies, and continued government efforts to stave off the necessary pains of adjustment.  He thinks the conditions are in place for a meltdown of overleveraged and inflated prices in several areas.  If you divide the amplitude of his forecast movements by two, and give them a 30% chance of happening, I think this is a reasonable and useful scenario for bond investors to consider.  In Part II, Tinder for an Interest rate Conflagration, I  summarize the evidence for potentially structural weaknesses that imply that such a scenario, should it arise, might be more extensive and sudden than the current market consensus seems to imply, and editorialize on appropriate risk management policies.