Long Rates Are The Recovery's Catch 22

In this economy, strong growth and falling long-term interest rates are as incompatible as Dan Quayle and Murphy Brown. Indeed, judging by the big July rally in the bond market, it seems as if a weak recovery is the only way to get long rates down.

It's a tough dilemma. The recovery desperately needs lower long-term rates to revitalize housing and other credit-sensitive sectors and to allow households to repair their debt-ridden balance sheets. But investors in fixed-income securities worry that the seeds of future inflation are planted in strong recoveries, particularly when there are gargantuan federal deficits to finance. So they protect themselves by demanding higher yields on any sign that the economy is picking up steam.

Lately, those signs have been few and far between. In fact, the recovery looks so tenuous that consumers are losing faith. Job growth is too anemic to bring down the unemployment rate. Income gains are too puny to support a strong rebound in spending. And factory managers are so nonplussed that they are hesitant to expand their output, payrolls, and facilities.


All this disappointing news has not escaped the sharp eyes of the bond market. On July 29, the yield on 30-year Treasury bonds broke below Januarys five-year low of 7.39% (chart), before finally closing at 7.45%. In just the past month, long-term interest rates have fallen by one-half percentage point.

The bond-market rally suggests a sea change in the psychology of fixed-income investors. They now seem convinced that the recovery is too weak to generate price pressures that might erode yields. Moreover, this downshift in inflation expectations, combined with weak growth and less-than-expected borrowing by the Treasury this quarter, is likely to allow long rates to drift even lower during the summer.

The good news for the economy is that lower long-term rates will keep the recovery moving along in the second halfif only at a snails pace. Most important, the steep decline in rates is sparking another upswing in the housing market.

Mortgage applications for home purchases in July are back to their high level of January, says the Mortgage Bankers Assn. That's encouraging, because home buying fared poorly in the second quarter. Sales of existing homes fell 2.9% in June, to an annual rate of 3.36 million. It was the third straight decline in resales.

Lower mortgage rates can't do it all, though. Consumers must see a substantial pickup in jobs and incomes before they feel confident enough to undertake the biggest purchase most families ever make. Right now, however, the inability of this recovery to create jobs is causing increased uncertainty among consumers.


Indeed, Americas mood turned decidedly downbeat in July. The Conference Boards index of consumer confidence tumbled 11.6 points, to 61, last monththe lowest level since March (chart).

The drop, apparent in almost all regions, reflected growing pessimism about current business conditions and the economys prospects six months from now. The decline in the confidence index also echoed a reported three-point drop in the early July results of the University of Michigans survey of consumer sentiment.

What's worrying consumers? Employment prospects. The Conference Board reports that the percentage of consumers who felt jobs were hard to get rose to 44.1%, from 40.6% in June. And a growing number believe that even fewer jobs will be available six months from now.

The Conference Board also notes that the Presidential campaign "is probably contributing to some public uncertainty and concern." That's especially true because the main focus of this year's campaign is the economy. The board said about a third of the July responses were completed during or after the Democratic convention.

The July performance mirrors the plunge that confidence took earlier this year. But those winter blues didnt prevent consumers from going on a first-quarter spending spree. And at least one economic report suggests that consumers may have cured their summer blues with a shopping trip as well.

The Johnson Redbook Service, published by brokerage firm Lynch, Jones & Ryan Inc., reports that buying at department and chain stores soared in the first two weeks of July. Hot weather spurred purchases of summer clothing, air conditioners, and garden equipment. Sales so far in July are up 4.7% from June, Johnson Redbook says. Although general merchandise sales account for only about 12% of all retail buying, a pickup in spending there suggests stronger demand overall.

The Redbook also predicts that the upcoming Christmas shopping season will be the best in four years. The report forecasts that department stores, discounters, and retail chains will see their combined sales rise 6% this holiday season compared with last November and December, when sales edged up by just 3.7%.

Consumers may be able to spend more freely this Christmas because lower interest rates will help shore up their financial foundations. One example: Lower rates have touched off a second wave of mortgage refinancings, which will put more money in homeowners pockets. However, job growth between now and yearend will be the key determinant of holiday shopping.


The halting nature of the recovery, though, has been the primary reason for business hesitancy about beefing up payrolls. In addition, weak demand is keeping up the pressure to cut costs. For example, the trickle of new orders gives manufacturers no incentive to lift output beyond their existing capacity.

Makers of durable goods posted a 2.3% increase in orders in June, but that only offset Mays 2.2% decline. Order gains in recent months have been so weak that the volume of bookings is still well below that for shipments (chart). The result: The backlog of unfilled orders, which typically begins to rise in a recovery, is still falling. It dropped 0.7% in June, the 10th consecutive decline. A falling backlog does not engender enough confidence in the future for factories to lift output or payrolls.

Little wonder then that Dun & Bradstreet Corp.s latest survey of manufacturers shows that factories were less optimistic in June about industry conditions for the three months ahead. In fact, confidence flagged for the second consecutive month, led by a sharp drop in optimism among durable-goods producers.

But its not just manufacturing that's under the gun. The pressure to keep work forces lean and costs down is pervasive across most industries, and it is the chief reason why the pace of labor costs continues to slow. The Labor Dept.s employment cost index, which measures both wages and benefits, rose only 0.8% in the second quarter.

During the past year, labor costs have risen 3.4%. The annual pace has slowed sharply, by two percentage points in only two years (chart). Wage growth, at only 2.9%, is now the slowest in five years. And the pace of benefits, down to 5.5%, has ebbed to the lowest rate in three years.

The slowdown in labor costs, combined with gains in productivity that reduce unit costs, is the main reason fixed-income investors have nothing to fear from inflation, certainly through next year. Until labor costs start to rise faster, there is no reason to worry that the wage-price spiral is gearing up again. Rather, labor costs seem more likely to slow further in 1993 in the face of a weak recovery and the drive to cut costs.

To be sure, any sign that lower interest rates are sparking a strong pickup in growth will quickly revive the inflation fears of investors. But for now, at least, the arguments for continued low inflation seem to be winning out. And the decline in long rates should open up enough room for the recovery to keep crawling along in the second half.

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