Monday, October 1, 2007

Lower Treasury Yields Suggests a Economic Slowdown Over the Next Two Quarters

Looks like banks that are large traders of US Treasury securities are flashing an economic slowdown over the next two quarters based on declining yields. The rate forecasts cannot predict whether or not there will be a recession, but an economic slowdown is clearly in the picture. From Bloomberg:

We will have a clearer picture of the economy at the end of this month (October) when the Bureau of Economic Analysis (US Dept. of Commerce) takes the first cut at GDP numbers for Q3, not to mention the revisions for Q2. Consumer spending (PCE) will be an interesting number to see. It has been declining since Q4 2006 on a year-over-year basis and Q3 was not that strong, so further declines are expected. Furthermore, Gross Domestic Private Investment (GPDI) has had lowering growth since Q2 2006 and negative growth since Q4 2006. This is also not expected to improve in Q3. PCE and GDPI combined comprise 87.4% of GDP, clearly the drivers of economic growth.

For the first time since 1995, the U.S. bond market is rallying on the assumption that the Federal Reserve has relegated inflation to a secondary concern because the central bank views a recession as a much greater threat to the economy. (my emphasis)

The bellwether 10-year Treasury note, which depreciated as its yield climbed at least a quarter-percentage point when the Fed began lowering interest rates in 1998 and 2001, won't be recoiling anytime soon after the Fed lowered its benchmark by half a point to 4.75 percent on Sept. 18, the first cut in four years. Instead, the 10-year yield will fall to 4.51 percent by year-end from 4.58 percent, according to the median forecast of the 21 securities firms that trade with the central bank.

``The Fed will be easing'' again, said Neal Soss, chief economist at Credit Suisse in New York, who expects ``some further rally in Treasuries.''

The bond market's unusual buoyancy is a consequence of the worst U.S. housing slump in 16 years, a slowing rate of inflation and the seventh weekly decline in short-term corporate lending to companies. The sudden convergence of these disinflationary forces helped make the third quarter the best for government debt in five years. (my emphasis) I also wonder if part of the decrease in yield is a flight to quality both with US and international investors.

Treasury yields tended to rise in the past 12 years when the Fed lowered borrowing costs on concern that inflation would quicken and reduce the value of fixed interest payments. The last time they fell as the Fed reduced its target for overnight loans between banks was in 1995.
Ten-year yields rose 25 basis points in the six months following the Fed's first cut in January 2001. They climbed 75 basis points by March 1999 after policy makers reduced rates the previous September. In 1995, yields fell 45 basis points once the Fed started lowering borrowing costs in July and said inflation had receded. A basis point is 0.01 percentage point.

This time the Fed is easing amid a slowdown in consumer price gains. The personal consumption expenditures index excluding food and energy, the measure of inflation policy makers use in making their semi-annual forecasts, rose 1.8 percent in August from a year earlier, the smallest increase since February 2004, the Commerce Department said Sept. 28. (my emphasis)

``The trend in inflation has been pretty tame and we don't expect anything to change,'' said James O'Sullivan, a senior economist at UBS Securities LLC in Stamford, Connecticut. UBS predicts that the 10-year yield will be at 4.5 percent in March.

While inflation is slowing, some economists are concerned that the Fed's focus on growth will spark price increases. Policy makers including Chairman Ben S. Bernanke have said their ``comfort zone'' is from 1 percent to 2 percent in the core personal consumption expenditures index.

``Inflation will become more of an issue over time for investors,'' said Dean Maki, chief U.S. economist at Barclays Capital Inc. in New York. ``Expectations of aggressive Fed easing from here will gradually fade.''

``The current Fed policy abets a flight path of lower but still positive growth, with moderate inflation,'' he said in prepared remarks to Middle Tennessee State University in Murfreesboro, Tennessee. ``More turbulence may be ahead.'' (my emphasis)

Sales of new homes declined 8.3 percent to an annual pace of 795,000 in August, the slowest in more than seven years, the Commerce Department said Sept. 27 in Washington. The median price plunged 7.5 percent from a year ago, the biggest drop since 1970. (my emphasis)

The amount of commercial paper outstanding, or debt maturing in 270 days or less, has fallen $369.2 billion, or 17 percent, to a seasonally adjusted $1.86 trillion since peaking in July as some borrowers were shut out of the market, Fed data show.

Goldman Sachs Group Inc., the world's largest securities firm and its most profitable, last week reduced its forecast for U.S. gross domestic product growth in 2008 to 1.8 percent from 2.6 percent. The New York-based firm expects 10-year yields to decline to 4.2 percent by April as the Fed lowers rates to 4 percent.

Only Merrill Lynch is more bullish on yields than Goldman Sachs and the unit of Zurich-based Credit Suisse Group, forecasting 4.15 percent by the end of March, the survey showed. Merrill Lynch expects policy makers to lower their target rate to 3.75 percent by the end of the first quarter.

Treasuries may already reflect slower growth, according to economists at some of the dealers.
``Bond yields are going to be pretty flat going forward,'' said Ethan Harris, chief U.S. economist in New York at Lehman Brothers Holdings Inc. ``There will be upward pressure on yields as the financial markets' panic stops and fewer people are jumping into safety.'' At the same time ``there will be weaker growth putting downward pressure on yields.''

Following are the results of Bloomberg's survey of primary dealers, conducted from Sept. 24 to Sept. 28 (By the way, Fed means Fed Funds rate, 2s are 2-year Treasuries, and 10s are 10-year Treasuries):

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