EconPundit

The most interesting market development in recent days has been the decline in long-term US yields, occurring against a background of (a) consistently robust economic news, and (b) a weak dollar exchange rate. This market development suggests that investors finally are coming to believe -- correctly, in our view -- that the Fed will be far more patient with its 1% short rate than has been widely imagined. The exceptionally low November CPI data may have been the main catalyst for this change in opinion.

There is potential for the yield drop to keep on surprising in its speed and intensity, based on technical considerations. To wit, the 10-year Treasury yield is now below 4.15% but above 4.00%, and it has spent very little time in this zone since the beginning of the year. This means we may have entered an "air pocket" where there are few price commitments, and the yield could fall quickly to test the next area where substantial investment activities took place, around 4% or a bit below. That would come as a very big surprise to those in the financial community who currently seem to see the Fed as pursuing an inflationist course.

Whereas most observers seem to regard the Fed's current strategy of maintaining rock-bottom rates indefinitely as an inflationists' dream, we look at it as a rational approach given (a) lingering risks of an unacceptable drift toward zero or negative inflation, and (b) the US ecconomy's historically heavy private debt loads.

The November CPI report highlights the continuation of disinflation, with the core measure (excluding food and energy) down 0.1% month/month and up just 1.1% year/year. Moreover, on a chain-linked basis the core is up only 0.7% from November 2002. With excess capacity at upwards of 2% of GDP, there is a real danger that by late 2004 chain-linked core retail inflation will be under 0.5% and flirting with nil, even if the economy grows at 4%-5% in the interim. Were a negative growth shock to occur, true consumer goods and services inflation might reach the zero line by late 2004/early 2005.

The FOMC should keep short rates around 1% indefinitely while disinflation at retail is occurring. The main danger is a further slip in core services pricing might undermine the recovery in employment that is just getting underway, by damaging the profitability of these enterprises.

Two reports this morning reinforce our hunch that the fourth-quarter real GDP rise will be in the neighborhood of 5.5%-6.5%, rather than the roughly 4% result most analysts have been anticipating.

First, retail sales in November rose 0.4% excluding vehicles, and were revised up moderately as well. This means the core retail sales data (excluding autos, building materials, and gasoline) is trending up at a 4.6% annual rate this quarter, rather than the prior 3.2% indication. That alone adds about 0.6% to real GDP growth, all else equal.

Second, it looks more likely that a desired inventory rebuilding effort is now underway. Total manufacturing and trade stocks rose 0.4% in October, the second straight gain of that magnitude (following an upward revision to September). The new information in this report concerns retail inventories, which in the nonauto sector rose 0.2%. Ex-autos, the retail inventory/sales ratio rose for the second straight month, the first time that has happened in almost a year. Thus, it appears that managers in this sector are no longer comfortable with running down their stockpiles as they were through most of this year.

The FOMC statement today has formally de-linked the "considerable period" language used for describing their comfort with extraordinary accommodation from a tilt in their views about the medium-range risks to growth or the inflation level. While the language does say the risks of higher inflation are not quite equal yet to those of an unwated further diminution of pricing pressures, for all intents and purposes this was a "neutral" statement in the traditional sense. That is signaled by their characterization of the expansion as "brisk" and admission that employment is no longer just stabilizing but has actually improved, albeit modestly.

The important implication is that the Committee has shown they are comfortable with keeping rates at 1% for a long time even if growth is strong, because they perceive significant slack in resource usage and therefore essentially no danger of a breakout in inflation within the next 18 months or longer. Probably a large number of members, if not a majority, still expects core inflation to edge down a bit more between now and mid-2004.

Judging from a number of recent reports, the rebound in stockbuilding by US firms may be coming a lot faster than analysts have anticipated. If so, then the real GDP growth rate this quarter once again would surprise on the upside versus consensus expectations of around 4% (my current guess is it will actually come in around 6%).

The factory inventory figures released last Friday fit with this notion. Total inventories were merely flat in October, but that followed 0.3%-0.4% declines in each of the four prior months. If sustained for all of this quarter, I calculate this would add about $20 billion to the nonfarm inventory growth rate from this one sector alone.

Moreover, the composition of the inventory growth shift is interesting because it has all occurred at the work-in-process stage. Finished goods stocks continue to be liquidated, and in fact this rundown accelerated to 0.5% from 0.2%. This suggests that pressure to beef up production remains strong, which helps to explain the robustness of the November purchasning managers' reports.

Despite a disappointingly small rise in payrolls (+57,000, held down by the California grocery strike), the employment data from November overall had a very firm tone, showing fresh evidence of rallying demand for labor. In particular:

1. Total hours worked remain on a strong uptrend. The annualized pace of increase for Q4 is 3.1%, which if sustained would be the highest since late 2000 and is far above the Q3 result (-0.7%). A longer workweek, both overall and in manufacturing, bodes for faster hiring increases in future months.

2. Diffusion of job growth is impressive. The 3-month diffusion figures (measuring the percent of industry groups with more employees than three months ago) have turned up sharply, to 53.8% overall (from 34.5% in August) and 62.7% in nonmanufacturing sectors (from 41.4% in August). Also, the one-month diffusion figure was higher in November than in October (54.7% v. 53.6%), signalling that even though jobs grew by less the breadth of those gains is spreading.

3. Household survey shows huge employment gains. This separate count -- which better incorporates new and small business hiring, as well as self-employment -- was up 589,000 in November in total, and 627,000 in private nonagricultural fields.

4. Unemployment fell, and the composition improved. Not only was the unemployment rate down 0.1%, to 5.9%, but within the jobless count there was a decided shift toward voluntary unemployment, as job leavers rose to 10.8% from 8.9%.

The one genuinely weak area was wages, with average hourly earnings up 0.1% on the month and just 1.4% annualized in the past six months. This means that, for now, the income consequences from higher employment are being muted somewhat. Thus, disinflationary forces remain at work, and that will reinforce Greenspan's preference for patience with very low rates.

The ISM factory and nonmanufacturing surveys both revealed surprisingly strong results in the employment components. Today the latter report showed a 2-point rise in employment to 54.9%, the high since March 2000. These survey data are consistent with other evidence (e.g., significant declines in initial and continuing unemployment claims) that the labor market has turned up to a notable degree this quarter.

It looks to me that the civilian unemployment rate should drop 0.1% to 6.0% (the unrounded rate in October was 5.98%, so you need only a 45,000 dip in the jobless count to pull the headline figure down a notch). Payrolls are projected to climb 150,000 held down by a 63,000 surge in striking workers (California grocery employees).

While not all the figures from the companies are yet available, based on current information it appears the selling rate for cars and light trucks in November was slightly shy of the projected 16.5-million annual rate. Ford in particular posted weaker-than-expected results, which is surprising given they have just introduced a major new pickup truck model.

The evidence increasingly suggests that the vehicle sales surge over the summer was fueled largely by the one-off tax rebates, which amid favorable financing pulled forward sales from the later months of 2003. Consequently, producers may need to trim their inventories via production cuts (Ford announced a Q4 cut of 20,000 units today, all of which obviously will take place in December when seasonal factors will inflate its impact on adjusted data).

The latest OFHEO quarterly report on house price gains showed the smallest year/year rise since late 1999. Prices for idential houses rose 5.6% in Q3 from the same period of 2002. This is somewhat at odds with the figures from the National Association of Realtors, which indicate a 8.2% year/year rise in prices for existing home sales. However, the OFHEO numbers are typically more robust as they are quarterly and based only on repeat sales of the same dwelling.

At this point, the residential real estate market is red-hot for both sales and construction. However, there are some straws in the wind that suggest that two or three quarters out things could turn down, maybe with a vengeance. The New York Times over the weekend highlighted the weakness in rental prices in big city areas, which is possibly a signal of overbuilding and excess credit availability for purchase activities and construction. Also, the Comerce Dept. figures show the absolute level of new-home inventories climbing at a brisk pace for the first time, even with sales running over 1 million annualized.

The surge in the ISM manufacturing index to 62.8% (from 57%) puts it in very rarified ground from a historical perspective. This is the highest monthly reading since December 1983, when the economy was on the verge of blowing its top in terms of growth for six to nine months. Compositionally, the data are just as impressive. For example, the gap between the new orders and inventory indexes (+23.7%) is the widest since September 1975. This suggests that the inventory replenishment phase of the expansion is fully underway and will provide major impetus to output and income growth for many months.

Bond yields have jumped on the news (10-year up 8 basis points), but in truth the dangers are skewed toward an even bigger smash-up in fixed income markets. This report and others (e.g., construction spending +0.9% in October) point toward Q4 growth being closer to 6%-8% rather than the 3.5%-5.0% numbers being tossed around. That would mean six months of nominal GDP growth averaging 8% or more, which is hardly consistent with 5-year yields in the 3.5% zone and 10-years at 4.40%. There is genuine danger that we are just beginning another big spike up in long-term yields, which will carry them to levels that will pierce the mortgage refinancing market severely.