U.S.: The First Economic Casualty of War: The Bond Market
Current forecasts for the U.S. economy after the war are all over the place. But one thing is clear: Unless the war effort goes horribly awry, the first air strike will most likely mark the end of the three-year rally in the bond market, where long-term interest rates on everything from mortgages to corporate bonds to Treasury issues have fallen by some three percentage points.
Yields on 10-year Treasuries have already risen by more than a quarter point since Mar. 12 in heightened anticipation of the initial assault (chart). As war-related uncertainty begins to clear, the belief that the war will be quick has taken over market thinking. As a result, the flight to quality, which has depressed stock prices and lifted bond prices, pushing long rates lower, has reversed course.
But this U-turn will be more than a short-term reaction. A successful war effort will permanently reduce geopolitical risk, a factor that will help stocks at the expense of bonds. More important, spending by consumers and businesses will improve at least gradually after the war, lifting pricing power and economic growth. Early signs of increased pricing power in Corporate America are already cropping up. Finally, the prospect of budget deficits and heavy government borrowing will once again enter the bond market equation.
Given that cheap financing has been a major support under this lackluster recovery, the specter of higher long-term rates raises important questions regarding housing, consumer spending, and business investment. However, there is no need to fear a turnaround in the bond market. In fact, long rates typically rise after a recession, as the economy gains strength. Their decline during the past year has been the anomaly, reflecting the unusual set of factors weighing on this recovery.
WAR WILL BE THE CATALYST for rising long-term rates, because it will begin to lift the veil of uncertainty that has covered the financial markets and business decision-making. Even policymakers at the Federal Reserve are unwilling to make bets on the economy's near-term future right now: At its Mar. 18 meeting, the Fed decided to refrain from an official assessment of the risks facing the economy, even as it held short-term rates steady. But the Fed noted it would maintain "heightened surveillance" of how the war plays out, a sign the bank is ready to cut rates if needed.
But once the war is resolved, investors will be more willing to assume risk, opening up more financing opportunities and making safer investments less attractive. Risk spreads between corporate bonds and riskless Treasuries will most likely narrow, indicating a general easing of financial conditions.
Beyond the war's initial impetus for higher long rates, perhaps the most critical factor in coming months will be stronger demand, as consumer and business confidence comes out of the cellar. Clearly, the excesses of the late 1990s still weigh on the economy, and a robust rebound in demand remains many months away.
But the bond market always looks ahead. And the postwar economic data are likely to indicate that real gross domestic growth in the second half will improve over the paltry 1% to 2% pace that is shaping up in the first half. Remember, prior to the economy falling into its soft patch, 10-year Treasuries were trading generally above 5%, and that was when real GDP was growing at a moderate 3% pace.
AS DEMAND STRENGTHENS, so will pricing power, always a key factor in setting long rates. Don't worry: Inflation is not about to surge. However, an upturn in import prices (chart), past reductions in industrial capacity, and the increased costs that tighter security have placed on supply channels make a potent recipe for better pricing power, especially against a backdrop of stronger demand. Inflation expectations, which have been beaten down by talk of deflation, have nowhere to go but up. And at some point, the Fed, which has been happy to err on the side of an extremely generous monetary policy, will have to lift short-term rates.
Nascent signs of stronger pricing power are already evident in nonoil prices for goods in the early stages of production. Core prices for raw materials in February, which exclude energy and food, surged 15% ahead of their year-ago level. This time last year, prices were down 6.4% from the prior year. Further up the production line, core prices for partially processed intermediate goods have accelerated to a 2.6% yearly growth rate, up from -2% a year ago and the fastest clip in more than two years. These trends hardly suggest that deflation is an imminent threat.
Core finished-goods prices have been essentially flat for about two years, but that could change in coming months, especially as the trade-weighted dollar's 13% decline from last year's peak feeds into higher import prices. At their worst, prices for nonoil imports were falling 5.4% per year, but now they are up 1.6%, the fastest pace in two years. Higher import prices give U.S. producers cover to lift domestic prices.
Plus, given a recent gaffe by Treasury Secretary John Snow on his view of the dollar's recent slide, currency traders are starting to question the White House's commitment to a strong-dollar policy. So a further decline in the greenback, along with higher import prices, seems likely, especially in light of the enormous U.S. current-account deficit, which now stands at a record 5.2% of GDP. That's an imbalance that can be redressed only by a weaker dollar.
PRICING POWER will also get a lift from ongoing efforts to eliminate excess production capacity. Outside of tech industries, capacity in basic manufacturing, which was growing at a peak rate of 4% per year back in 1998, posted outright declines for most of the past year (chart). Growth in tech capacity, which peaked at 55% annually, is now only 9%. Clearly, more shrinkage is warranted, especially in tech equipment, but many industries are becoming very lean, even relative to the current sluggish pace of demand.
Finally, bond investors are starting to cast a wary eye on the return of federal budget deficits that could hit 4% of GDP. Right now, with the economy struggling, the markets can easily meet the modest credit demands of both the private sector and Washington. But as the economy picks up, and as the full brunt of new Treasury borrowing hits the market, public and private demands for funds will start to collide as they did in the 1980s and early 1990s.
Clearly, the outlook for long-term rates will depend heavily on the path of the economy. If the war goes poorly or generates unintended consequences that negatively affect the U.S. and global outlook, then all bets for a turnaround in the bond market are off. However, under the best-case scenario, a quick war that removes uncertainty and clears the way for better demand growth in the second half will start long rates on a steady upward climb that may well continue right on into 2004.
By James C. Cooper & Kathleen Madigan