Rate Surge With Rising U.S. Confidence a Positive Sign

Photographer: Richard Drew/AP Photo

Specialist Charles Boedinghaus, foreground, check a board at his post on the floor of the New York Stock Exchange on Aug. 16, 2013. Close

Specialist Charles Boedinghaus, foreground, check a board at his post on the floor of... Read More

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Photographer: Richard Drew/AP Photo

Specialist Charles Boedinghaus, foreground, check a board at his post on the floor of the New York Stock Exchange on Aug. 16, 2013.

Concern that a surge in U.S. bond yields will curb the expansion is overblown, says money manager James Paulsen. When coupled with gains in confidence, higher borrowing costs are a healthy sign for the world’s largest economy.

“Confidence is at the center of everything here,” said Paulsen, the chief investment strategist at Wells Capital Management in Minneapolis with $340 billion in assets under management. “If I had to pick one overriding thing, it’s confidence that’s been running through the financial markets and the economy this year.”

Since 1967, stocks have risen at a 12.8 percent annualized rate in months when bond yields and the Conference Board’s consumer confidence measure rise in tandem, according Paulsen’s research. When borrowing costs increase and confidence drops, stocks -- a proxy for investors’ views on the direction of the economy and corporate profits -- have fallen at a 6.4 percent rate.

Currently, consumers are the least pessimistic in more than five years, homebuilders are the most upbeat since 2005 and purchasing managers say their factories are churning out goods at the fastest pace in almost a decade. That improving economic outlook is one reason that Federal Reserve Chairman Ben S. Bernanke may opt to slow the monthly pace of $85 billion in bond purchases as soon as the Fed’s Sept. 17-18 meeting.

Treasury Yields

The yield on the benchmark 10-year Treasury note rose to 2.88 percent late yesterday, reaching two-year highs for a third consecutive day, as investors become increasingly convinced the Fed next month will reduce how much stimulus it pumps into the economy. The yield had been as low as 1.63 percent on May 2.

Yields on U.S. corporate bonds from the riskiest to most-creditworthy borrowers have climbed to 4.23 percent from a record-low 3.35 percent on May 2, according to the Bank of America Merrill Lynch U.S. Corporate & High Yield Index. They reached a one-year high of 4.3 percent on June 25.

So far this year, rising yields have been accompanied by improving confidence. The Bloomberg Consumer Comfort Index early this month reached the highest reading since January 2008. The New York-based Conference Board’s confidence gauge in June and July also had the strongest two months in more than five years. The Thomson Reuters/University of Michigan’s measure in July reached a six-year high, before falling this month.

Consumers’ Psyche

“Consumers are so far saying, ‘OK, employment is improving, growth is improving, maybe not evenly, maybe not fast, but it is improving,’” said Adrian Miller, director of fixed-income strategy at GMP Securities LLC in New York. “The back-up in interest rates of late, dramatic as it may be from early May, is not yet at a level that would creep into the psyche of the consumer as being a problem.”

The Standard & Poor’s 500 Index reached a record high on Aug. 2, and though the index has since dropped from that peak, equities remain up 15.4 percent so far this year through yesterday. Stocks rose, after a four-day drop in the S&P 500, as retailers’ results surpassed estimates. The S&P 500 climbed 0.4 percent to 1,652.35 at the close in New York.

“You have bond yields going up, but you have the equity market doing well,” Drew Matus, deputy U.S. chief economist at UBS Securities LLC in Stamford, Connecticut, and a former analyst at the Federal Reserve Bank of New York, said in an Aug. 16 interview on Bloomberg TV.

“What does that tell you?” said Matus. “It tells you the equity markets are going up because the economy is doing well or that bond yields are going up because the economy is doing well, not necessarily because of expectations of what the Fed may or may not do.”

Withdrawing Stimulus

The rise in yields is being closely monitored by Fed officials as they gauge whether the economy is strengthening to the point that they can withdraw stimulus or whether the rise in rates threatens to derail growth by raising borrowing costs and choking off activity.

Bernanke said in Senate testimony on July 18 that the rise in interest rates had led to an “unwelcome” tightening in financial conditions. He said that better growth expectations were also behind the rise in rates and added that “a benefit” of higher rates “is that some concerns about building financial risks are mitigated in that way.”

Homebuilders, among the groups most sensitive to a jump in borrowing costs, continue to gain confidence even as rates rise. The national average 30-year fixed mortgage rate was at 4.40 percent last week compared with a record low 3.31 percent in November, according to Freddie Mac.

Builder Sentiment

The National Association of Home Builders/Wells Fargo sentiment index climbed to 59 in August, the highest since November 2005.

“People are overreacting to a little run up in interest rates,” Donald Tomnitz, the president and chief executive officer of D.R. Horton Inc., the largest U.S. homebuilder by revenue, said on a July 25 teleconference. “It may delay those purchases, but it’s not going to be a permanent effect.”

Not everyone is sanguine about the effects on housing from higher rates.

“One of the fundamental underpinnings to this recovery has been the recovery in the housing market,” said Mark Luschini, chief investment strategist at Philadelphia-based Janney Montgomery Scott LLC. “Rising rates could choke up one of the things that helping boost household net worth, which is good for spending, as well as work counterproductively to things the Federal Reserve is attempting to do.”

Manufacturing Gauge

Manufacturing is another area that’s shown increased confidence. The Institute for Supply Management’s factory gauge jumped in July to the highest level in more than two years. The 4.5-point increase in the purchasers’ gauge from the prior month was the biggest since June 1996, the group’s production measure was the strongest since May 2004, and orders also advanced.

Since 1960, there have been only eight cases in which the ISM index has seen comparable “outsized” gains in production and orders that did not reflect rebounds from “sharp” declines a month earlier, according to research by Joseph Carson, director of global economic research at AllianceBernstein LP in New York, with $435 billion in assets under management.

Six of those periods occurred in the very early stages of an economic recovery following a recession, and in all cases gross domestic product picked up over the next year, he said.

“The manufacturing survey really surprised me in terms of its strength,” said Carson. “It’s a gain that usually signals the start of the cycle, which is really surprising given that we are in the fifth year of this cycle.”

Economic Recovery

The recovery from the last economic slump started in June 2009, according to the National Bureau of Economic Research, the accepted arbiter of when U.S. recessions begin and end.

The recent jump in interest rates “reflects both a reassessment of economic performance and a reassessment of the Fed’s intentions,” Carson said.

Carson isn’t the only one taken aback by recent strength in economic data. The Citigroup Economic Surprise Index, a daily gauge of how close analysts get to predicting the actual outcome of economic reports, reached 40.6 on Aug. 15, the highest level of the year. A higher index shows results of the most-recent data are more positive and surprising.

Bond yields began jumping in May when Fed officials started discussing the possibility that monthly bond purchases would be trimmed this year. The Federal Open Market Committee will opt for tapering at the September meeting according to 65 percent of 48 respondents in an Aug. 9-13 Bloomberg survey. The median estimate called for purchases to be cut to $75 billion.

“We haven’t seen the disaster that some had feared and now they can think about tapering,” said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut, and a former Federal Reserve Bank of Richmond economist. “You have the opportunity to pull back. The market is prepared for it.”

To contact the reporters on this story: Joshua Zumbrun in Washington at jzumbrun@bloomberg.net; Victoria Stilwell in Washington at vstilwell1@bloomberg.net

To contact the editor responsible for this story: Chris Wellisz at cwellisz@bloomberg.net

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