What Will It Take To Please The Bond Market?

All together now, repeat the bond market's new mantra: Weak is strong, down is up, and slow is fast. Got it? O.K. Now you're ready to be a trader in this market.

You would have done especially well on Apr. 28, when the Commerce Dept. reported on first-quarter economic growth. The pace of real gross domestic product slowed sharply from a robust 7% in the fourth quarter of 1993 to a lower-than-expected 2.6%. Any coldly objective reading of the report showed modest, noninflationary growth. Grounds for a rally, right? Wrong. The bond market launched into a furious sell-off. Recent massive intervention to support the dollar has only heightened market tension.

The fact is, real GDP remains far from any reasonable measure of what the economy is capable of producing--that is, if all of its labor and output capacity were fully employed (chart). Inflationary pressures do not even begin to build until the economy reaches this potential level of GDP. The Federal Reserve pegs the economy's potential growth at 2.4%. But because of improving productivity, that level could well be in the range of 3%-3.5%.

The bond mavens ignore such arguments, of course, focusing instead on the acceleration in the first-quarter GDP price index to 2.9% from 2.3% in the fourth quarter. Never mind that the speedup reflected a onetime federal pay raise and a quirk in the way import prices enter the index. The price index for gross domestic purchases, which sidesteps that quirk, rose only 2.3% in both the fourth and first quarters.

Bond folk also said that first-quarter growth was blunted by bad weather, the Los Angeles earthquake, and unsustainably large declines in government expenditures and net exports. As a result, they said, real GDP growth would rebound strongly in the second quarter, perhaps to 41/2% or 5%.

Right now, however, about 3% looks more reasonable--and that is not enough to fuel inflation. While the Federal Reserve's latest regional survey of business activity through Apr. 25 showed generally "solid economic growth," it also noted that price pressures remained "restrained."

It's true, weather and the quake were negatives, but as a percent of GDP, the impact was small. Also, postquake rebuilding will be stretched out over a long time, and much of the weather-related losses in retail sales and industrial production will not be made up.

Government outlays did drop a steep $14.9 billion last quarter, mainly reflecting an $11 billion decline in federal spending. But most of that fall occurred in defense, which is still in a long-term shrinkage and unlikely to bounce back this quarter. A $3.9 billion falloff in state and local outlays does appear questionable, though, since the bad weather forced unusually large outlays for snow removal and highway cleanup.

Likewise, some improvement in net exports seems plausible. A widening in the deficit between imports and exports, by itself, subtracted $19.7 billion from first-quarter growth, more than 11/2 percentage points of growth. However, any second-quarter bounce may be small. Although exports, which plunged last quarter, should start growing again, imports grew at a far lower rate than they had during the previous year. Faster growth there will offset the export rebound.

More important, though, the bond market ignored two key GDP components that are likely to contribute much less to second-quarter growth than they did last quarter: consumer spending and business inventories.

Nonfarm inventories grew by $30.7 billion in the first quarter, the largest accumulation in six years (chart). Some of that pileup was probably unintended, because of weather-depressed sales, and it will have to be worked off. Already, manufacturers reported a 0.1% dip in their March inventories, even as new orders rose 1.1%.

Also, surging auto production accounted for much of the overall rise in stock levels, and auto output in the second quarter is already scheduled to be well below the first-quarter level. The coming slowdown in inventory building could subtract as much as a percentage point from second-quarter GDP growth.

The surprising buildup in nonfarm inventories suggests that industrial output, which soared at a 7.7% clip last quarter, will begin to slow. The April report from the National Association of Purchasing Management shows that production will downshift this spring, but not stall out, while inflation continues to exist more in the minds of bond traders than in the reality of industrial-price lists.

The NAPM's index of industrial activity rose to 57.7%, from 56.7% in March. The production index slowed a bit, but employment rose to a five-year peak. The NAPM said new orders remained at their high levels of February and March, with export demand rising. Plus, the index of order backlogs jumped five points, to 61.5%, in April.

In addition, the NAPM price index, which set off the bond bears when it rose sharply in February, has now fallen for two consecutive months (chart).

Crucial to any discussion of future U.S. economic growth is the outlook for consumer spending, since it accounts for two-thirds of GDP. Real personal outlays grew at an annual rate of 3.8% after a 4.4% shopping spree in the second half of 1993. Will shoppers keep spending at nearly a 4% pace in this quarter?

Probably not, especially since April spending may have been crimped by two unrelated events: taxes, which meant households had a little less cash to spend, and an earlier-than-usual Easter that pushed some retail buying into March.

A slowdown in spending last month is already evident in the preliminary data from retailers. The Johnson Redbook Report says sales at department and chain stores slipped 0.2% from March. And April vehicle sales were also below March's. A sluggish April suggests a slower second quarter: If spending is weak in the first month of a quarter, it's harder for the quarterly average to post a big increase.

However, the upward trend in disposable income suggests that spending should recover quickly in May and beyond. Real aftertax earnings grew at an annual rate of 2.7% in the first quarter, but the gain would have been higher except for the income lost due to the earthquake and the harsh winter. Incomes should grow above 3% this quarter, setting the pace for a 3% gain in household spending as well.

Stronger consumer fundamentals also helped to lift the government's index of leading indicators by 0.7% in March. Three of the four biggest contributors to the hike were consumer-related: a longer workweek, more homebuilding permits, and fewer jobless claims. The rise in the index confirms the economy's steady upward course (chart).

The spring quarter may also see one last rush of home buying. Construction was battered by last winter's weather: The GDP data showed that nonresidential construction fell at a 16.1% pace and the rise in residential building slowed to 9% from a torrid 31.7% advance in the fourth quarter.

Some bounceback seems assured this spring. Construction spending, reported monthly, already shows a 0.8% rebound in March, after building outlays dropped 2.3% in January and 1% in February. Moreover, new single-family home sales increased 11.1% in March, to an annual rate of 739,000, as buyers moved to lock in still-low mortgage rates. The drag from higher mortgage rates is likely to show up in the third quarter.

Of course, that's exactly what the bond market is aiming for: slower economic growth. But as the first quarter shows, the market doesn't seem happy even when it gets what it wants. So if you want to score in this market, just keep repeating: Weak is strong, down is up, slow is fast.

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