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Today's Commentary: 03.16.04
Bond Investing: In the Absence of Deflation
Last year, as the summer started to heat up weather-wise, the bond market cooled off. The dramatic dip in the ten year note to 3.11% yield was based on a good deal of speculation about deflation. Greenspan expressed his worry and the markets understood those concerns. With a 1% overnight rate, many, including myself, thought the Fed had no room left to move.
Little has changed since then except for the verbiage. Now, the chances of inflation are equally weighted, balancing, or canceling each other out. The bond market is still focused on the actions of the Fed, ignoring the talk. As the ten year note reaches for those lows of a year ago, the question begs to be asked: Are you so bearish that 3.75% over ten years actually looks attractive?
How about 3.50%? While the Fed is suggesting that patience is required in order to allow the economy to recover, the low interest environment has caused a higher amount of mortgage refinancing. This has caused prepayments which will raise prices which, as bond investors know, lowers yields. In order to believe that bonds will test last year's low, you have to believe that the fundamentals are disappointing at best.
Inflation, which is difficult to gauge without numbers - the PPI for January and February have been withheld - is directly effected by globalization, productivity, and the jobs market.
While the effects of globalization involve heated debates about outsourcing and free trade, better left for another column - perhaps later this week - productivity will always have a disinflationary effect on the economy. When the job markets stagnate along with a sustainable rise in productivity, the effects keep prices down. The inability of producers to raise prices even in a weak dollar environment is troublesome.
The bond market believes in natural expansions when it comes to the job market. And that folks, has yet to happen even if you average the two widely separated reports on labor. The household survey states a more positive outlook than the payroll survey for good reason. Any employment is considered good among those who buy the increases in the household survey as indicative of growth in the labor force even if that work pays less. But companies, at least 62% of them in the recent quarterly survey conducted by the Manpower Corporation have no intention of replacing workers. But, many companies are hiring workers from such temporary employment agencies - hardly a vote of employment confidence.
If the job market shows significant improvement, and that would have to come at the addition of 150,000 jobs per month - not the paltry 42,000 that has been added on average - the Fed can rest on their current assumptions for the remainder of the year.
A 3.5% yield on long term government bonds, a low not seen since 1958, is now being spoken about as a real possibility. Consumer confidence is just not where it should be according to the most recent polls. Unless the belief that the national economy is improving along with job prospects, do not expect the consumer to continue to spend at previous rates.
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