The Interest Rate Conundrum: The Chairman of the Fed recently gave some interesting explanations of why the long end of the yield curve is not going up in tandem with the Funds rate as would be the case under the economic theory that long-rates are the average of the expected future short-rates:

We think there are other factors responsible for the low level of long-term rates, but we also think that market forces will begin to lift the long end of the yield curve during the second half of this year. First, with respect to the globalization theory, we think it holds if we can assume that foreign investors are suckers for the U.S. dollar and are thrilled to finance our overspending at subsidized interest rates. In fact, the Fed Chairman’s statement about globalization has given rise to a new monthly headline in the financial media: "Look! foreign investors just bought a bunch of US Treasury securities last month, that must be a sign of confidence in our economy." However, currency markets can be ruthless and unpredictable in their response to external imbalances. The U.S. current account deficit has been expanding without historical precedent since 1998 and we expect the hemorrhaging to reach 6.3 percent of GDP this year. Absent any currency adjustment, the deficit could top 7.5 percent of GDP in 2006! We think there is a limit to how much globalization can help when a structurally imbalanced economy is becoming overly-dependent on easy financing from the rest of the world. This is reminiscent of the late 1960s, when Prime Minister Charles De Gaulle threatened to exchange all of the Bank of France’s dollar holdings into gold at the supposedly U.S.-guaranteed conversion rate.

The currency markets have exhibited a fair amount of volatility. The Euro has bounced around within a $1.2 - $1.34 band during the past year. However, we think the market will apply another dose of shock treatment before the end of this year in an effort to correct the out of control current account deficits. We continue to see the Euro reaching $1.50 - 1.55 per Euro before December 31, which would definitely make European policymakers very unhappy. It is not so much the strength of the European economy as the serious economic imbalances in the U.S. that will lead investors to pull out of the U.S. money markets, until the dollar sinks low enough to trigger a response in terms of diminished craving for imports. Such a currency market reaction would be accompanied by higher interest rates.

Economic activity appears to be slowing to a still healthy rate of growth. The latest WSJ survey shows GDP growth of 3.6 percent for 2005, compared to our own forecast of 3.25 percent. In our forecast, we apply a greater weight to the adverse impact of higher energy prices on aggregate demand in the economy. Industrial production, which is more vulnerable than the services sector to rising energy and raw materials prices slowed to an annual growth rate of 3.0 percent in April, down from 4.4 percent in December.

Consumer spending in the U.S. should continue to push the economy as long as the rest of the world is happy to pluck down the money to feed our consumption habits. Household debt service as a percent of disposable personal income reached a record 13.4 percent during the first quarter of this year. On the other hand, some analysts point to the trillions in additional consumer assets such as real estate, which are not counted as part of the denominator of this statistic. We doubt whether foreign investors can also be hoodwinked into buying our real estate properties such as our homes so that we could pay back some of the money we owe them.

The real estate jingle is sounding louder than ever with higher prices and healthy growth of building activity, when will the bubble burst? Clearly, low mortgage rates continue to support the unusually strong level of building activity particularly single and multifamily housing. However, the frequency of media and regulatory attention recently devoted to the question of a real estate bubble is a compelling argument that a correction in real estate prices is imminent, the question is when will the adjustment occur. Unfortunately, when two people meet and ask whether real estate prices are too high, and those two people in turn meet and ask the same question of others, and so on, eventually it becomes a self-fulfilling prophecy. Regulators have taken a cautious approach by labeling the problem one of regional bubbles. Mr. Greenspan has in fact referred to it as a regional "froth." We are not sure whether he is referring to "froth" as the aggregation of bubbles or an unsubstantial phenomenon. Housing bubbles, as opposed to the stock market bubble – or better known by the phrase "irrational exuberance" bubble - are localized in nature, since real estate is not a homogeneous nationally tradable commodity. A speculator in Miami usually buys properties in the local area, as opposed to buying real estate in California; but at the end of the day, the bursting of regional real estate bubbles will create national indigestion, particularly if the trigger happens to be rising long-term interest rates. When a kite goes down it does not matter whether you are the kite or the tail of the kite. We think regulators may be reluctant to apply the term "irrational Exuberance" to the real estate as opposed to the equities market, because of the large banking exposure to real estate financing.

Inflation is moderately accelerating. Our moving average measure of the CPI inflation was 3.1 percent in May, and we predict an inflation rate of 3.4 percent for this year. A new element in the inflation equation is the recent upturn in unit labor costs (ULC) in the non-farm business sector. ULC during the first quarter of this year was up 4.2 percent with respect to the same quarter in 2004.

Based on the above considerations, our take on the interest rate conundrum is as follows: