May 27, 2005
U.S. EconomyEven if the Fed continues to move the Funds rate up by 25 basis points at each of the remaining FOMC meetings this year, the year-end rate of 4.25 percent would still be 225 basis points lower than when it first started the steep descent in January 2001. Interestingly, in December 2000, the real – or inflation-adjusted interest rate, based on the 10 year bond, stood at 3.4 percent, with an inflation rate of also 3.4 percent. Based on our projected Fed Funds and 10 year bond rates for the end of this year, of 4.25 percent and 5.50 percent respectively, the implied real interest rate is expected to reach only 2.0 percent, up from 1.2 percent last month (See Special Analysis at the end of this section). With a huge external deficit and a significant fiscal deficit, thus raising the risk factor in the medium- to long-term, we think the risks are on the upside as far as the movement of the long-end of the yield curve is concerned. We expect the long-end to show some knee-jerk reaction to the build-up in inflationary pressures during the second half of this year.
With the economy slowing to a still very respectable growth rate of 3.4 percent for this year, some market analysts are hyperventilating over the likelihood of a recession. Some analysts were thrown into a panic following the release of the preliminary first quarter GDP growth of 3.1 percent, which was down from 3.8 percent in the fourth quarter. Depending on your view of life, either the economy is expanding at a sustainable rate of 3.1 percent, or it is experiencing a worrisome slowdown from 3.8 to 3.1percent. On the other hand, a moderately slower growth rate may help to keep inflationary pressures under control.
Consumers are still supporting the economic expansion, despite the rise in energy prices, while businesses are being somewhat more cautious. Personal consumption expenditures were up 3.5 percent during the first quarter, down from 4.2 percent in the fourth quarter. On the other hand, business investment expenditures expanded at a more moderate rate, particularly in the areas of industrial and transportation equipment. Even though growth of industrial production tapered off to an annual rate of 3.1 percent in April, down from 4.4 percent last December, we still think the economy will manage to post a moderately higher growth rate during the second quarter.
Inflationary pressures are becoming more noticeable. Our moving average CPI inflation measure stood at 3.1 percent in April, and we are now forecasting a rate of 3.7 percent by the end of this year. Consumer inflation expectations, based on the University of Michigan’s survey was at 3.3 percent in April, up from 3.2 percent in the previous month. Of course, if you subscribe to the so-called "superior" inflation measure based on the Personal Consumption Deflator, you would not be worried about inflation; however chances are that you will begin to experience sticker shock during the second half of this year.
Recent talk of the U.S. Treasury bringing back the 30 year bond will hopefully be a lesson that it is better not to tinker with the yield curve. On the other hand, the recommendation that the U.S. Treasury Department issue 30 year debt is a telling statement about expected increases in long-term interest rates. Back when the 30 year bond was retired from circulation all the fiscal talk in Washington was about how big the fiscal surplus was going to be in 2010. There was plenty of Irrational Exuberance in the U.S. Capitol at that time! On another related matter, the gross Federal debt has been on the rise again, after it peaked in 1995 at 66.5 percent of GDP, the ratio then shrank to 57.0 percent in 2001, and has been moving up rapidly reaching 62.7 percent last year.
Our growing external deficits are piling up U.S. external debt at approximately twice the rate that the government is issuing debt. The U.S. is becoming more dependent on external financing and thus vulnerable to foreign investor sentiment.
Special Analysis: An Anatomy of StratInfo’s Long-term bond forecast
Our persistent forecasts of higher long-term bond rates for this year calls for some explanation in view of Fed Chairman Greenspan’s characterization of the long-end yield curve connundrum. For that reason, we have provided some talking points as to the rationale for our 10 year bond rate forecast:
Factors behind the upswing in inflation:
Oil prices are expected to remain in the $47 - $55 price range for the next two years, and yes Virginia, there is a cost-push element to inflation, which can be accentuated by growth of demand and ample liquidity in the economy.
Other commodity prices: expanding world demand will keep prices high.
U.S. economic expansion: the StratInfo GDP forecast for 2005 of 3.4 percent growth represents a respectable expansion in demand for goods and services.
Devaluation of the dollar: as we have said since the beginning of this year, the Euro will reach $1.55 / Euro before the end of this year. In addition, we think the Chinese government is likely to revalue its currency by up to 40 percent, also adding to U.S. inflationary pressures.
Review of CPI Trends:
The moving average inflation rate based on the CPI (MA CPI) trended down from 5.0 percent in 1990 to 1.6 percent in 1998, when oil prices hit historical lows.
The MA CPI then headed back up and peaked at 3.5 percent during the first quarter of 2001 as oil prices strengthened.
With the onslaught of the 2001 recession, the MA CPI trended down again until the end of 2002, when it dipped to a low of 1.5 percent.
Since 2002, inflation (based on the MA CPI) has been moving up again, and had reached 3.1 percent by April of this year.
Trends in real interest rates based on the 10year Treasury bond:
Real interest rates were relatively high during the 1990s, with an average rate of 3.6 percent. During this period Congress was fantasizing about fiscal surpluses through the year 2010.
Real interest rates trended down beginning in 2001 mostly due to accelerating inflation: a knee-jerk response typical in financial markets.
When inflation then began to subside, starting in 2002 and through the first quarter of 2003, the same Pavlov type response drove up the real interest rate.
Once again as inflation begins to accelerate from 2003 – to the present, real rates fall to new lows, with the latest reading at 1.2 percent in April 2005.
From a forward looking perspectives, current real rates reflect some factors but do not appear to take into account others such as:
Higher inflation, 3.7 percent by year end.
The Fed’s divide-and-conquer strategy: create different measures of inflation which cause the market to become confused about the "real" inflation rate.
Real rates do not appear to account for still significant fiscal deficits, projected deficit of $365 billion for 2005 by CBO, and huge & growing trade deficits accompanied by greater volatility in the currency markets.
Where are nominal long-term interest rates headed?
Inflation expectations are a critical variable. The University of Michigan’s consumer inflation expectations measure has tracked very closely to our MA CPI, in fact during the 1990s, the difference between the MA CPI and the survey’s inflation expectation averaged 55 basis points.
The standard textbook equation for nominal long-term interest rates needs to be adjusted as follows: nominal interest rates = real interest rates + inflation expectations + the impact of the Fed’s Open Mouth policy.
Taking into consideration the above factors, we are projecting the real rate at 2.0 percent by the end of this year, and the MA CPI at 3.5 percent, which would imply a 10year Treasury bond rate of 5.50 percent, assuming the Fed abstains from further attempts to talk down bond rates or the markets simply focus on real trends in the economy.
The IMF and
Argentina are negotiating a new agreement. The IMF wants to complete a detailed analysis of the economic situation in Argentina, before initiating formal negotiations in July.The
Bolivian Congress finally passed a new energy law that imposes onerous royalty fees and taxes on energy companies operating in Bolivia. After saying that he would veto the law, President Mesa let it become effective without his signature, as a sign of displeasure. Mesa decided against the veto, after street demonstrations erupted across the nation. This law has not pleased anybody. The indigenous population and the unions want downright nationalization of the energy industry, while foreign investors mull a retreat.A
Brazilian Central Bank study shows that the recent real revaluation does not yet present a threat to Brazilian exports. According to the analysis, the currency rearrangement mostly represents US$ weakness. The real maintains its competitiveness against other currencies.Chile’s
Central Bank increased its benchmark interest rate from 3.0 percent to 3.25 percent. Additional hikes are expected, up to 4.0 percent by year end.Colombia
subscribed a new agreement with the IMF, after complying with all quantitative targets of the previous agreement. A reform of the budgetary process is still pending. The government also announced that it would discontinue its export subsidy program to banana and flower exporters that began last year.Construction activity in
Costa Rica has been sagging since last October due in part to higher interest rates.Dominican Republic reported GDP growth of 4.0 percent in the first quarter of this year.
Ecuador’s
new President Alfredo Palacio has been tapping members of conservative Alianza Democratica Nacional (National Democratic Alliance) for important positions in his government.El Salvador’s
maquila sector has lost twelve companies and 4,820 jobs, so far this year, due to competition from China.Family remittances to
Guatemala increased by 12.6 percent up to April.The
Honduras government expects an increase of 7.0 percent in exports this year.Mexico
reported GDP growth of 3.0 percent in the first quarter of this year.Nicaraguan
exports surged by 18 percent in the first three months of 2005. A significant increase was reported in sales abroad of sugar, coffee, gold, meat and beans.The
Panamanian economy grew by 9.0 percent in the first quarter, propelled by construction, exports and canal zone activity.A severe drought is heavily impacting agricultural production in
Paraguay.The
Peruvian government has proposed to the Paris Club the prepayment of between US1.5 billion and US$2.5 billion in debt.