THE BOND MARKET IS TURNING INTO THE VILLAIN OF THE PIECE
The 1992 recovery has made an enemy: the bond market. Even the slightest hint of a rebound sends traders into a selling frenzy that pushes up long-term interest rates. As a result, long rates have surged back toward levels that are putting a choke hold on an economy that's struggling to get back on its feet.
Lower long rates are the heart of the recovery mechanism. They give life to the upturns in housing and related industries, and they are critical to consumers and businesses that need to refinance heavy debts and thus get themselves into better shape to spend. But by mid-February, the rate on 30-year Treasury bonds had risen back to where it was in November (chart).
The bond market's hostilities were evident when it reacted to only a moderate gain in January retail sales as if the numbers were ushering in a consumer-led boom. The market ignored the downbeat implications for jobs and incomes contained in the January employment report, the plunge in industrial output, and the absence of inflationary pressures implied by falling producer prices and a slim gain in consumer prices.
The bond market is pushing rates up mainly out of fear that an economic recovery will coincide with what promises to be the largest Treasury-financing needs ever. In addition to the credit demands of a growing economy, a $400 billion federal deficit would mean that the government would be in the credit markets during the third quarter to borrow a staggering $3 billion a day. And Congress hasn't had its say on the 1993 budget.
The Federal Reserve didn't help matters on Feb. 18, when it cut the reserve requirement on bank deposits from 12% to 10%, effective on Apr. 2. The move is a moderate easing of monetary policy, and it further spooked the bond market by raising fears that the recovery could be stronger than expected and fuel inflation.
The Fed's action boosts banks' profitability by freeing some $9 billion in reserves that now can be invested in securities or used to make new loans. And down the road, new lending will help the economy.
For now, though, the Fed's move looks more political than tactical, since it came the day before Chairman Alan Greenspan went to Capitol Hill to deliver his semi-annual defense of monetary policy. The cut in the reserve requirement helped Greenspan dodge political pressure without cutting short-term interest rates. In fact, the move seems to underscore the Fed's recent aversion to further rate cuts. The Fed seems to be betting that past cuts are enough to spark an upturn.
Indeed, in his Feb. 19 testimony, Greenspan reiterated his belief that a "moderate" recovery would begin in the second quarter. For 1992, the Fed expects real gross domestic product to grow between 1.75% and 2.5%.
The chairman sounded especially upbeat on inflation. The Fed projects consumer prices will rise between 3% and 3.5% this year, and Greenspan expressed optimism for further improvement in 1993 and beyond "even as the economy expands." The chairman's comments seemed to be aimed at calming the jittery bond market.
To be sure, higher rates are a direct threat to the housing recovery, which is much more muted than January's 5.5% increase in housing starts, to 1.17 million, suggests. A big increase in starts of apartment buildings in the Midwest accounted for much of that gain. Starts in the much larger single-family sector rose only 0.9%. If mortgage rates rise above 9%, the longevity of this already modest housing upturn will be at risk.
Not even the impressive improvement in inflation has swayed the bond bears. Producer prices of finished goods fell 0.3% in January, the second consecutive decline, and consumer prices rose a scant 0.1%. During the past year, inflation at the consumer level has fallen to 2.6%, from 5.6% a year ago, largely because of falling energy prices. Even excluding energy and food, however, the core rate has dipped from 5.6% to 3.9%, the lowest in nearly five years (chart).
If the bond market is hypersensitive to a recovery, it is at least focusing its attention in the right place. It knows that consumers have to lead the upturn. A few household fundamentals have stabilized, but the necessary improvement in those supports still is lacking.
Some glimmerings: The University of Michigan's index of consumer sentiment edged up in early February. And new filings for jobless benefits have plateaued, suggesting that the labor markets have stopped deteriorating.
With those signs, bond traders latched onto the latest retail data as evidence of the recovery's arrival. Retail sales rose 0.6% in January, and revisions showed that November and December weren't as disastrous as first measured (chart). January sales at department and building-materials stores were especially strong.
Consumers started February on a stronger note, as well. New domestic-made cars sold at a good, though not spectacular, 6.4 million annual rate in early February. That's up from 5.9 million for all of January.
The problem is that rising interest rates and no growth in jobs or incomes may knock consumers out of the box. Indeed, jobs shrank by 91,000 in January, and weekly pay fell a sharp 0.7%. So where did consumers get the money for their January shopping spree?
The answer seems to be from mortgage refinancings. Applications for refinancings soared in January, as the mortgage rates dipped to nearly 8%. That liberated cash for many homeowners. Some of the money repaid old debts, but the rest was probably spent.
The danger now is that the bond market has closed the window of opportunity for consumers to lower their mortgage payments. The average 30-year mortgage rate has ticked up by half a percentage point in five weeks, to 8.8% by Feb. 14. Not surprisingly, applications for refinancings fell sharply in the final week of January and the first week of February.
That means shopping malls that were crowded in January could be emptier in later months. As it is, even with the increase in January, retail sales started the first quarter only about even with their average in the fourth quarter, after adjusting for inflation. The prognosis: Labor markets will have to improve, or consumers won't have the additional income to boost spending.
That's why the double dip in manufacturing dims the outlook. Industrial output plunged 0.9% in January, after cuts in November and December (chart). Operating rates for all industry fell from 78.8% in December to 78% in January--the lowest rate in 7 1/2 years. Output cuts and mothballed equipment mean workers will not be added.
Factory output fell 1% in January, led by a dizzying 8.2% drop in auto production. But even outside the car industry, production was down 0.6%. The defense industry was a big loser, but there also were declines in industrial machinery, oil and gas equipment, and materials. That reflects the sluggishness in new orders, and inventory troubles, especially at retailers.
Business inventories rose by 0.4% in December, but factory stockpiles shrank by 0.5%, the 10th drawdown in a year. Retailers, however, saw inventories balloon by a large 1.2%, their sixth consecutive increase.
Excluding autos, retail stock levels are up for nine months in a row, with a big buildup in nondurable goods. Even with the upward revisions to yearend retail sales, the ratio of nonauto inventories to sales is at its highest level in the 19 years of record-keeping.
Until these excess goods are sold, retailers won't order many new products. That means factories will have little reason to gear up assembly lines--or hire new workers.
The new twist in the outlook is that the jump in interest rates hampers consumers' efforts to clean up their finances. That could hurt spending and keep retail inventories excessively high. The economy is in a catch-22: The bond market, which thinks a recovery is budding, may in fact be killing off the upturn at its roots.JAMES C. COOPER AND KATHLEEN MADIGAN