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Hot Summer, Cool Prices, Rising Rates

By David Wyss The U.S. economy is heating up even more than expected this summer. Led by the consumer, who has finally managed to save absolutely nothing, growth appears to be strengthening despite the drag of rising gasoline prices and the 10th consecutive Fed interest rate hike. Although I continue to worry about another surge in oil prices and potential disruptions in international financial markets, the economy is so far doing better than anticipated and seems likely to remain on a steady growth course.

But inflation remains very modest. Even with the continued climb of oil prices to new records, the core consumer price index (excluding food and energy) is up only 2% from a year earlier, a deceleration from the rate in spring. High productivity growth and the recent strength in the dollar have kept inflation low, despite continued increases in health-benefit costs.

Having done so again on Aug. 9, the Federal Reserve will continue to raise interest rates. Under this scenario, the Fed's "conundrum," that long-term rates have dropped while it has been raising short-term rates, appears to be easing. The 10-year Treasury yield has risen to 4.4%, more in line with current federal funds rates. We expect the Fed to continue to tighten, pushing the funds rate up to 4.25% by yearend.

EXTRA "INCOME." Energy is taking a bigger share of consumers' budgets, but Americans are offsetting that by saving less and borrowing more. Household debt hit a record 123% of aftertax income at the end of the first quarter. Most of the rise is in mortgage debt, but nonmortgage borrowing was up $14.5 billion in June (8.2% at an annual rate).

The ability to refinance at lower mortgage rates has contributed to the spending spree. Households took out $139 billion in cash-out refinancings last year and increased their home-equity loans by $178 billion. The added $317 billion was 3.7% of last year's household disposable income. Without that extra "income," spending might have been much weaker.

Consumers can't continue to live this far beyond their means. As interest rates rise, the cost of servicing the debt will increase (although only slowly, since most consumer debt is fixed-rate). The easy borrowing that's boosting spending today will come back to cut spending tomorrow. If interest rates rise slowly, as we at Standard & Poor's expect, the problem will be modest. But if they soar, consumer spending could drop sharply.

A YIELD CURVE PROBLEM? The U.S. economy is becoming more sensitive to interest rates at the same time the Fed seems to be losing its power to control them. Alan Greenspan & Co. have now raised rates 10 times since June, 2004, from 1% to 3.5% on the federal funds rate. Yet long-term bond yields are still below where they were when the Fed started to tighten (4.4% vs. 4.8% for the 10-year Treasury note).

The flattening of the yield curve shouldn't be a major issue. Although some commentators say it implies that the economy is about to slow, no historical evidence supports that statement. On average, the 10-year yield has been one-percentage point higher than the fed funds rate since 1960. When the yield curve has been steep (more than a percentage point), real GDP has risen an average 4.3% over the following four quarters. When it has been flat (between zero and one), growth has been 3.7%.

However, when the yield curve inverts (10-year yield below the fed funds rate), growth averages only 1.1%, and most of the time there has been a recession.

MORE APPETIZING RATES. The stock market has actually done better when the yield curve is flat than when it's steep. In periods when the curve is steep, stock prices have averaged 9.8% over the following four quarters. When flat, stocks have been up 11.7%. However, when the yield curve inverts, stocks are up an average of only 1.5%.

I don't expect the yield curve to invert, since I think long-term rates will rise. They've been held back so far by the inflow of money from abroad, both from central banks seeking to stem the decline of the dollar and foreign investors looking for better returns than are available in Europe or Japan. The 4.4% available in the U.S. doesn't look very appetizing, but it beats the 3.3% on German bonds or the 1.4% in Japan. But if investors get leery of the dollar, they're going to demand bigger yield differentials before exposing themselves to the risk.

The reintroduction of the 30-year Treasury next February will have little direct impact on bond yields. What counts most is how much the federal government is borrowing, not the exact maturities. However, longer-term assets have seen strong demand. Both France and Britain recently introduced 50-year bonds and found the sales oversubscribed.

The 30-year Treasury's maturity is also substantially longer than the usual corporate maturity, so investors looking for the shorter-term assets would face less competition for those bonds, and they would likely get lower yields, albeit marginally. Wyss is chief economist for Standard & Poor's

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