Don't Lose Too Much Sleep Over Higher Rates And A Stronger Dollarby
Housing and exports are expected to play important roles in the U.S. recovery. Because of that, there is a growing concern that rising interest rates and a stronger dollar will sink the upturn's chances before it even sets sail. The argument is neat and sounds compelling. It's also probably wrong.
To be sure, fewer homes will be bought at 9% mortgage rates than at 8%. However, the real juice that will fuel the housing rebound is better growth in jobs and incomes that will make people feel confident enough to plunk down the money for such a major purchase. On that front, the latest readings on household incomes and consumer spirits look stronger.
Despite the uptick in rates in February, sales of existing homes rose sharply. They jumped 9.3% in the month, to an annual rate of 3.52 million. That was the largest monthly increase in nine years, which goes back to the early months of the recovery from the 1981-82 recession. The surge pushed resales to the highest level in three years. The rise in rates even may have contributed to the gain, as buyers sensed that rates were bottoming out. Higher interest rates have also pushed up the dollar, which could make American goods more expensive in world markets. However, foreign demand has always been far less important to recovery than domestic demand, which is nine times larger.
Besides, the biggest threat to U.S. exports right now is not the dollar. The rise in the trade-weighted dollar in recent months has been tiny. The real problem is the flagging economies of our industrial trading partners. But even there, surging demand in the developing nations is taking up some of the slack.
WHY THE CREDIT MARKETS ARE JUMPY
The domestic impact from the backup in long-term interest rates is the more worrisome issue. It threatens further gains in housing and other credit-sensitive goods, and it retards balance-sheet repair for debt-laden households and businesses. After inflation is subtracted, the rise in real rates is especially troubling (chart).
The rate on 30-year Treasury bonds rose back to 8.1% by mid-March, from 7.4% only two months ago. And the rate for 30-year mortgages averaged 9.1% in the week of Mar. 20, up from a 17-year low of 8.3% in mid-January.
So far, though, the rise in long rates is not out of line with the upticks that have typically occurred at the onset of past recoveries. Rates are generally back to where they were last October, when the economy was showing signs of slipping back into recession. However, the recovery petered out last year because jobs and incomes failed to grow, not because of high long-term rates.
Long rates have been climbing for two reasons. First, after the robust-looking economic data in recent weeks, the credit markets are not yet convinced that the recovery will be modest enough to hold down inflation. Also, traders continue to worry about the river of Treasury debt that will be raging through the markets later this year, because of the widening federal budget deficit.
The Treasury's red ink in February was $48.8 billion, nearly double that for February, 1991. So far in the 1992 fiscal year, which began in October, outlays are rising as revenues fail to grow (chart).
The 1992 deficit is likely to come in below the $400 billion projected by the Administration's Office of Management & Budget, but not much below. And new government projections show deficits as far as the eye can see--into the next millennium. All this imposes potential inflationary pressures from government policy that the credit markets cannot ignore.
Since market rates comprise real rates plus expected inflation, it's clear from the upward tilt of market rates minus current inflation that the credit markets are not yet convinced that inflation will stay down. The rate on 30-year Treasuries minus core inflation has climbed to a three-year high. Core inflation, which excludes price swings in energy and food, has fallen to the lowest yearly rate in more than eight years.
A BOND RALLY MAY BE BREWING
In the near term, the inflation indicators should remain favorable. That means traders may be in for a change in sentiment that will allow market rates to ease back a little, or at least stop rising. That's particularly true if the data continue to signal that the recovery will be subpar by the standards of past upturns.
Indeed, bond yields have retreated from their mid-March highs partly in response to the latest tepid-looking numbers on car sales and new factory orders. By Mar. 25, the yield on 30-year Treasuries had slipped to just over 7.9%. That was the same day the government reported that new orders for durable goods dipped 0.1% in February, to $120.5 billion (chart). The news wasn't all bad, though. Excluding a big drop in military demand, orders rose 1.3%, and factory shipments jumped 2.9%.
However, the backlog of unfilled orders fell in February, a sign that factories may not yet have enough work to start calling back laid-off employees. Auto-industry orders rose in February, but sales of U.S.-made cars slipped in mid-March to an annual rate of 5.8 million, down from 6 million in early March.
THE SLUMP ABROAD MAY HIT HOME
Another concern about rising long-term interest rates is the upward pressure they place on the U.S. dollar. But the shift in the dollar isn't the only factor in this year's uninspiring outlook for foreign trade. Weak foreign economies will hold back export growth, and a U.S. recovery means increased demand for imports here.
In January, the merchandise trade deficit fell, to $5.8 billion from $6 billion in December. Imports dropped 1.4%, to $41.3 billion, probably reflecting the overhang of inventories at yearend, especially in the retail sector. Now, though, buying by consumers has perked up, and inventories are in better shape, so imports are likely to bounce back in coming months.
Exports also declined in January, by 1%. It was their third consecutive loss, and the falloff was fairly widespread among the major export categories. Still, the drop reflected soft export prices as much as it did a decline in volume, which fell by 0.5%. The question is whether the recent runup in the dollar's value will put pressure on U.S. exporters to raise their prices abroad.
There is not much muscle behind the dollar's new strength, however. True, the foreign exchange value of the dollar vs. the currencies of America's major trading partners has risen by about 6% since the beginning of 1992. But the dollar is back only to where it stood in October. And the greenback still has a long way to go before it reaches its recent peak, hit in mid-1989 (chart).
The U.S. currency is likely to strengthen some more in coming weeks, especially if foreign central banks cut interest rates in response to their respective nations' economic slumps. In fact, the slowdowns in other economies, in particular Japan and Europe, are much more worrisome for U.S. exports than the dollar's value.
Although less-developed countries, such as those in Latin America and on the Pacific Rim, have accounted for all of the growth in exports over the past year, the bulk of U.S. goods is still shipped to the industrialized nations. The fourth-quarter decline in the Japanese economy and the continued rise in unemployment in Europe are signs that demand from two of the U.S.'s biggest markets will weaken this year.
Demand from nontraditional markets will help exports to grow this year, although at a fairly moderate pace. But with the U.S. economy on the mend, imports will also increase, after falling 1.4% in 1991. These upward trends in exports and imports suggest that the trade deficit will make little, if any, headway this year.
Last year, without improvement in foreign trade, real gross domestic product would have fallen instead of edging higher. But this year, trade will not play such a pivotal role--regardless of the dollar's rise. Moreover, the weak outlook for trade is another reason why the recovery will be subdued, and a modest upturn will keep upward pressure off inflation and interest rates.