EconPundit

Today's market activities have the feel that the reflationists, having been run out of Dodge for the past month or two, are back in town and feeling their oats again. Not only are stock prices surging (Dow up around 100 points and back above 10000, NASDAQ up 1-3/4% and flirting from below with its 200-day moving average), but commodity prices have exploded to the upside (gold up $7/oz, CRB up nearly 4 points led by former favorites silver and copper), and the dollar is weak particularly against the yen. Thus, all the trades that were so popular a few months ago (long yen vs. dollar, long industrial commodities, long technology and small-cap stocks) but blew up in the faces of leveraged speculators are back in fashion once again.

These price swings are likely to prove ephemeral, and the reflationists should get spanked again for their enthusiasm, for one big reason. Several months ago, two key components of the reflation hypothesis were: (1) China was not going to slow down, and (2) the Fed would do nothing to upset the applecart by raising rates, so bond yields would stay low. Both of those considerations no longer apply in my view. The Chinese authorities have been as clear as they can be that they are going to slow their economy, even to the extent of shutting off loans to key industries. And though the Fed is trying to sound calm and collected, their rhetoric has made an obvious change toward more anxiety about inflation. More important, the bond market is definitely on the case for higher rates, and has received nothing but further provocation from recent robust economic growth news and much worse-than-expected inflation data.

The best bet, therefore, is that soon in response to the reflationist revival, the bond vigilantes will mete out their form of justice by driving yields to new highs. This should cause demand for commodities and stocks to come unglued once again, and this time perhaps to an even more damaging degree.

New data from the US Treasury show that foreign net sales of US stocks in March of this year hit $13.5 billion, a record liquidation for any month. This sharp sale -- all by the private sector -- followed some months of strong inflows to stocks from abroad. Nevertheless, it is noteworthy that overseas private investors have dumped more shares lately than they did at other times in the past when there were far stronger provocations. For example, in September 2001 net private foreign sales of US stocks were $11.8 billion, and in September 1998 amid the LTCM market crisis the net sales were $10.5 billion.

It is another negative signal for the US equity market outlook that foreigners have begun to sell in this sort of volume. All that remains is for the small domestic investor base to get nervous and start to reduce the very large stock mutual fund positions they have built, and the flows would be in line with the charts suggesting further substantial declines in prices lie directly ahead.

The guts of the New York Fed's latest manufacturing survey, dated May, is stronger than would be implied just by looking at the headline figure, which itself remained in very strong territory (30.2% vs. 34.0% on a revised basis for April). New orders, shipments, unfilled orders, employment, prices paid and prices received all were stronger from a month ago. In fact, when one applies the same weights as those used in the ISM factory composite, the NY Empire survey would yield its strongest result ever, up about 4 points.

Thus, it does not look as though the exceptional strength in manufacturing momentum is yet fading away. The best bet remains that there will be a substantial acceleration in overall real GDP growth this quarter, to something like 6%-8% from the 4.2% advance first-quarter gain.

Two April statistical reports this morning have further elevated the already-powerful pressures on the Fed to tighten policy sooner and by more than the markets have been discounting. At this point, the positive gap between what the data and the markets indicate should be the federal funds rate and what it is has expanded to such a point that current Fed policy appears almost ludicrous. As I've said before, these are precisely the kinds of conditions that have given rise to bond and equity market crashes in the past.

There was no good news in the latest consumer price report. The CPI rose 0.3% excluding food and energy last month, even though none of the more volatile goods categories was up (apparel flat, new cars and tobacco both down 0.1%). Commodity prices excluding food and energy have not fallen in any of the four months thus far in 2004, their firmest pattern in at least three years. Meanwhile, services excluding energy were up 0.4%, following a 0.5% gain in March, and this large group (50%+ of the total CPI) has put in what appears to be a clear upturn.

Industrial activity was robust in April, consistent with the ISM data but far stronger than what analysts had projected based on the factory employment and hours figures. Total industrial production rose 0.8%, as did manufacturing outside of motor vehicles. Nonauto factory output is currently on a 8% annual growth path this quarter, compared to 6.6% in the first period.

Look for some Fed official shortly to make comments massaging market expectations toward an earlier, larger tightening than has been suggested to date.

The inflation data keeps surprising to the upside. Signs of exceptional bottleneck development in the ISM survey of manufacturers have been present for several months, and now we are seeing remarkable strength in prices for unfinished goods among domestic producers apparently as a consequence of these conditions. This bodes unfavorably for retail goods price trends in the months ahead.

The PPI for intermediate goods excluding food and energy pole vaulted up 1.1% in April, versus an average monthly 0.7% gain in the first quarter and 0.2% in the fourth period of 2003. At 7.5% annualized, the pace of price increase in this sector over the past six months is the highest in almost 9 years. Although the core PPI for finished goods increased only 0.2%, it marked a fourth consecutive monthly increase for the first time since summer 2001. Clearly, goods pricing has strengthened a great deal in a short space of time, and this reflects the unexpected rapid growth of demand on the factory floor for which they had inadequate inventories and staffing.

Much of the unfinished goods price strength will likely come out of producers' profits in the near term. However, the speed of incline will induce them to look for places where they can defend profit margins with higher finished-goods charges. Hence, this report will add to the already-strong pressures on the Fed to move rates up very soon and by a lot unless the financial market environment suddenly turns hostile to growth prospects.

Despite an outsized rise in the US trade deficit during March (to $46.0bn from a revised $42.1bn), the trade data reveal new signs of an incipient US economic boom where the growth engine is hitting on all cylinders simultaneously for the first time since 2000. This is not a bearish sign for the dollar's exchange value; indeed, contrary to current conventional wisdom it could be regarded as strengthening the case for a further dollar rally. I maintain a bullish view on the dollar index (now 91.32), expecting to hit 92.50 in the near term with a good chance we will reach the 95.00 level by summer if not earlier.

Exports are rising rapidly, up 2.6% overall but up 3% in volume terms within the goods sector. Real goods exports jumped 7-1/2% annualized last quarter, and are up nearly 9% year/year. This is hardly a sign of an excessively high dollar value, especially when overseas demand trends are mixed at best. Meanwhile, imports exploded up, by 4.6% both overall and in price-adjusted terms among goods. This jump in imports, however, is precisely what one should expect when an economy has just entered a positive inventory accumulation phase fed by robust sales and excessive leanness in stockpiles.

In my view, the market is grossly misreading this report as a sign of economic softness and a basis for dollar bearishness due to persistently high and growing current-account deficits. We had a similar phenomenon in early 1987, when the markets initially thought a narrowing trade deficit was bullish for the bond market because it would stoke foreign demand for securities, but instead the acceleration of exports was a key component of an economic growth surge that pushed bond yields up 300 basis points right before the October stock-market crash. Watch for the dollar to change direction and head back up, whipsawing those who sold it in the hole this morning.

The April jobs report confirmed our suspicions that the labor market was finally kicking into a high gear, as the pressure on businesses to add workers in response to sustained strong demands and inadequate production/falling inventories had become too great to ignore. This was the message of the two ISM surveys and the factory orders report, and the financial markets are just now waking up to the implications. The main adjustment will be in perceptions of how much tightening the Fed and the bond market may face to get to "neutral," as that is much higher than previously thought now that economic growth appears to have developed self-reinforcing and self-sustaining momentum at last. One consequence should be much cheaper equity valuations, and that's particularly true in light of the ridiculous complacency evident in the stock-jockey community from recent surveys. An abrupt stock-market tumble or even a crash cannot be ruled out, as this may now be required to let off the enormous pressure building on the Fed to jack rates up very swiftly.

Key points from the employment news:

1. Average monthly payroll gains of 300,000 or more are now to be expected. Including revisions, the net change in employment reported today was 354,000. The stated average for March/April is 312,000. This is perfectly in line with what we have seen in other data, and this was the reason we projected a 300,000 gain.

2. Diffusion of job expansion has improved markedly across industries. Manufacturers hired 21,000 last month, including 22,000 production workers, and in fact with revisions the factory group now shows three consecutive monthly increases in payrolls for the first time since April 2000. In the nonmanufacturing group, 64% of industries added workers last month, and 68.2% over the past three months. The latter figure is also at a 4-year high.

3. Household survey data confirm the pickup in job creation. Employment in nonagricultural wage and salary positions (a parallel to the nonfarm payrolls series) was up 309,000 for the month, an even greater rise in percentage terms than what we saw in the establishment survey. Persons who are working part-time for economic reasons also continue to trend lower, suggesting that more businesses are being forced to add full-time workers.

4. The unemployment drop (-0.1% to 5.6%) was genuine. In fact, the unrounded rate was 5.56%, so the report just missed generating a new low in the headline unemployment rate. Also, this decline in joblessness occurred despite a rise in teenage unemployment -- a volatile series that is hard to seasonally adjust. With jobs now apparently on a track to grow 300,000+ per month, the unemployment rate could fall to 5.0% by election day which would be the lowest since September 2001.

This morning's news of a plunge in first-time unemployment insurance claims during the May 1 week, to a 3-1/2-year low of 315,000, adds to the weight of evidence that employment growth is likely to surprise on the upside for awhile. My expectation for the April payrolls figure due tomorrow is +300,000, and indeed that could become the new norm for monthly jobs expansion in the second and third quarters in light of recent evidence.

All signs are flashing for a period of robust, perhaps extraordinary, economic growth in the US. Factories are experiencing huge order gains, and have not come close to matching this with production and hiring thus far. This is why supplier deliveries are slowing to an extreme degree, and unfilled order backlogs are inflating at a double-digit annual pace. Inventory/sales ratios in manufacturing are falling at a 8%-10% annual rate. The ISM nonmanufacturing survey shows similar conditions have spread into other parts of the economy. Firms have been greatly surprised by the sustained, high demand gains, and have understaffed and understocked as a result of their caution. This means we could be just entering a big catch-up phase for output and employment. People should go back and look at the kinds of employment growth we have seen in the past, when ISM figures have been this high -- growth rates of 0.3% per month are common, which given today's labor force size would translate to around 400,000 monthly payroll advances. This could well be repeated now.

Such a surge in job creation would probably cause a spike up in anxiety about the Fed being too slow to raise interest rates, which would be severely negative for global capital markets. As discussed earlier, a loss of Fed credibility on policy (and even the New York Times is already calling for an immediate rate hike!) might cause the bond market to come completely unglued and overshoot massively to the downside, as convexity hedging from the mortgage sector kicked in again. Yields on the 10-year note this morning are already testing the 4.60% and higher level, as we had suspected they would before the week is out. If our suspicions on the job market are confirmed, look for last year's high of 4.64% to be broken and we might see a race up in the yield toward 4.90-5.00%. In turn, this could send a temblor through the US and global equity markets.

Not only was the ISM manufacturing report robust (see comment on May 3), but the group's separate nonmanufacturing report for April turned out to be blockbuster strong. The overall index jumped to a new-record 68.4% in April, from a March level of 65.8% which was the previous record. The two-month average 67.1% is almost 4 points above any prior similar measure.

The strongest elements of the report were new orders (up nearly 3 points to 65.6%), export orders (62.0% vs. 51.5%, not seasonally adjusted), and prices paid (a new high of 68.6%). In addition, employment growth accelerated further, to 54.5% from 53.9%, and supplier delivery speeds continue to slow sharply.

Comments from respondents were impressive in that they suggest a good deal of surprise at how strong activity has become, and a lack of preparedness for more of the same. For example: "General business conditions improving"; "Activity this quarter continues to exceed budgeted projection"; "Improving picture — hiring freeze has been lifted"; "General conditions have been very strong, reflecting increased consumer activity"; and "Business seems to have turned on a dime. Our company has never seen anything like it. We are concerned the increase in demand might be short-lived."

This report adds weight to my concern that the Fed has misjudged the current dangers surrounding its policy profile, and will soon be perceived as hopelessly behind the curve in the policy tightening outlook. This could be death to the bond market.

Yesterday's FOMC meeting outcome in its broad strokes was thoroughly unsurprising: no change in rates, a change in language to make up/down risks on inflation balanced, a recognition that economic data (especially employment) has strengthened, and deletion of the phrase "can be patient" with regard to unwinding of the Fed's monetary accommodation. All of this had been broadly expected. Yet, this was an extremely important meeting and the statement that emerged was weak and represents a gamble by the Fed with its all-important policy credibility.

The key language was in the final paragraph of the FOMC statement: "At this juncture, with inflation low and resource use slack, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured." This final clause reveals that a removal of policy accommodation is now seen as appropriate and necessary, but only at a very gradual speed.

What is very dangerous about this latest official statement is that it (a) recognizes that interest rates have to go up, and fairly soon, but (b) presumes that this can be done in a very "measured," cautious fashion rather than swiftly. As the next FOMC meeting is not for another 8 weeks, and intermeeting moves are highly unusual, in practical reality the decision leaves for at least two months the first baby step in what everyone including the Fed now deems to be a necessary task. This is akin to a high school student facing a major term paper that amounts to 50% or more of the semester grade, and having the assignment in hand, yet putting off any action on it for two months.

The hard fact is that if the Fed now agrees with the vast bulk of market participants that interest rates need to rise, it would be far better to get moving on it rather than to sit on their hands for a long further period. All that does is keep a sword dangling over the head of market participants and, more importantly, expose the Fed to danger that it has underestimated the business cycle momentum and will ultimately come under pressure to face a much bigger job in which it is much further behind than it wants to admit. The guess here is that the economic news will continue to surprise on the upside, and this will make the market view the Fed as being out of touch and way behind the policy curve -- attitudes that in the past have been a recipe for capital market disasters (see e.g. fall 1987).

I believe there is an excellent trading opportunity now to go short the October 2004 federal funds rate futures at the latest price of 98.485 (1.515% rate). There are four FOMC meetings scheduled between now and October 1: May 4 (today), June 29-30, August 10, and September 21. When risk premia are extracted (about 1bp a month at a minimum), the October contract price discounts an average FF rate after these four meetings of under 1.5%, close to 1.45%. However, if the economy is set to post very strong growth for another 3-6 months at a minimum, and the Fed is just waking up to the dangers of seeing excess supply dwindle very rapidly, then they could raise rates starting in June and by 25-50bp per meeting thereafter. Hence, it would not be at all surprising to see the October contract fall to a point where it is pricing 1.75-2.00% fed funds before it expires. I would expect this trade to net at least 30bp before mid-summer.

It is hard to exaggerate how strong are the March factory orders, shipments, and inventories data released today. In essence, they confirm that the extreme strength in the ISM manufacturing reports was providing an accurate picture of a sharp rise in goods-producing activity and pressures for expansion in that segment of the economy. Key statistics:

1. Total new orders were up 4.3% month/month, almost double the expected rise.

2. Gains were very widespread, with nondurable goods bookings up 3.5% (the most in 2-1/2 years) and durable goods up 5.0% (revised up from the advance +3.4% estimate).

3. Within durable goods industries, orders were revised up sharply for capital goods excluding defense and aircraft (4.5% vs. 2.4%), as well as for consumer goods and durable materials (6.5% vs. 4.9%).

4. Unfilled order backlogs are soaring. They rose 1.2% overall, including a 1.9% surge in the core that excludes defense and aircraft industries, and which tends to best represent shorter-term production pressures. In the capital goods sector, orders ex. defense and aircraft were up 1.8% last month and are climbing at almost a 10% annual rate so far in 2004.

5. The inventory/sales ratio has fallen significantly further, to 1.23 for all manufacturing compared to 1.27 in the fourth quarter. This is more than a 10% annual rate of decline, and it bodes for an early, rapid restocking effort that will further strain factory capacity.

This kind of strength in factory activity is seen very rarely -- only twice in the past 25 years, during early 1984 and late 1987. Typically it is associated with extremely rapid employment and GDP growth, and also aggressive Fed monetary tightening. In those earlier periods, the Fed had already tightened by more than 100bp when signs of such strength emerged. This time, they have not even begun to raise rates and it would seem they are at least 7 weeks away from doing so.

From this perspective, there is a high danger that the Fed will signal shortly (this afternoon?) that they are much closer to raising rates by a large amount than the market now discounts. This could crush the short and intermediate part of the yield curve, as well as the stock market. These are very dangerous fundamental conditions for the capital markets.

The April ISM manufacturing survey data present negative results from the standpoint of bullish bond investors from several perspectives:

1. Activity growth remains robust. The overall ISM factory index was about unchanged, at 62.4%, in line with the unusually strong results of the prior three months on average. We now have six consecutive months with the ISM factory composite above 60%, and such a long stretch has not occurred since late 1983/early 1984, when the economy was just emerging from back-to-back deep recessions. Thus, this represents exceptionally strong growth in production and demand within the goods portion of the economy.

2. Inflationary indicators are worrisome. The price index hit 88%, a 25-year high, and vendor performance (measuring the slowness of delivery speeds) stayed very high at 67.1% (versus 67.9%). Firms are having a very hard time keeping up with production demand, and are feeling a pinch on profits from rising input costs. This is a classic recipe for price hikes wherever these can be passed through.

3. Employment looks unusually positive. The employment component moved up to 57.8% from 57.0%, marking the first time such high back-to-back readings have occured in this survey since the end of 1983. This bodes for a further upturn in manufacturing payroll results when April data are released on Friday.

Taken together, these should be very bad omens for bond markets, auguring another large increase in yields in the near term. Look for the 4.64% high yield in the 10-year Treasury set last summer to be violated later this week.

At long last, the major media have begun to report on the story we have promoted for months that the US budget deficit is going to be far narrower this fiscal year than had been officially projected-- closer to $400 billion than $500 billion, with a best-estimate around $415 billion (see our comment on April 14). What finally seems to have forced this recognition is the Treasury's official borrowing estimate for the April/September period, issued yesterday afternoon. This forecast totals $129 billion, which if accurate would mean that the full-year market borrowing total would be something like $390 billion. That is grossly inconsistent with the $500-billion deficit forecasts that had been making the rounds, and far more consistent with a budget gap of slightly over $400 billion. See this article:

http://www.washingtonpost.com/ac2/wp-dyn/A64130-2004May3?language=printer

In my view, the bond market is likely very soon to put in a temporary bottom and rally sharply for at least a couple of weeks. However, it would not be surprising if first the yield on 10-year notes rose even further, to or above the 4.64% high set last summer. That would trigger technical selling on top of the extreme bearishness that already exists in the portfolio and hedge fund communities, creating an excellent recipe for a (temporary?) extreme oversold condition and a bottom. Thereafter, even mildly weaker-than-expected economic data or (quite possibly) a stock-market breakdown could spark a sharp, sustained rally in bonds. This might carry yields down 30-60 basis points, back toward 4% on the Treasury 10-year note.

Bond yields currently look very stretched to the upside relative to historical norms under an adaptive expectations model of behavior. At 4.50%, the constant-maturity yield on the Treasury 10-year is 1.65 standard deviations above normal relative to the 3-year moving average of short rates and a risk premium. This is UNPRECEDENTED for a period in which the Fed has not yet even begun to tighten -- in fact, under its latest policy directive the Fed is saying they can be "patient" before raising rates! Yet the bond market is already priced for a roughly 3.0-3.25% equilibrium money-market rate, roughly 200bp above the current trailing average. In past cycles, this degree of pessimism about future rate changes has never been seen prior to any rate hike by the Fed.

In its current pricing, the bond market closely resembles its state just prior to the 1987 stock-market crash. At that time, the 10-year Treasury went to around 10% while the trailing 3-year average of the money-market rate was around 6-1/2%, and the risk premium norm for the 10-year was around 160bp. Thus, at 10% the 10-year was pricing in a FF rate of approximately 8-1/2%, or 200bp above the recent trailing average. The panic that existed at that time in the fixed-income market helped to trigger the dramatic change in equity market sentiment that reached fruition in the October 19, 1987 crash (-22% in one day). What is extraordinary is that today, many analysts have no problem speaking of a 10-year yield rising to or above 5% -- up still another 50bp -- in the same sentence as predicting strength in the stock market.

My guess is we'll see lower lows in bonds next week, as market participants factor in further bearishness based on: (a) strong economic activity data and expectations for more, including the employment report on May 7, (b) the removal of the "patient" clause in the FOMC directive on May 4, and (c) looming Treasury debt supply with the May refunding. These three forces are apt to drive yields up to or above 4.64% from 4.50% today. If that happens, it could present a fantastic tactical buying opportunity for long Treasuries.