Bond market rally causing lower interest rates

Real Estate Weekly, June 25, 1997 by David X. Stumpf

We have downsized Corporate America and at the same time lowered the national debt. A balanced budget deal in Washington is almost certain, and, that may mean a cut in the capital gains tax. The surge in the economy has caused a surplus in the government coffers. The federal deficit is the lowest it has been in over 15 years. Even Federal Reserve Chairman Alan Greenspan must have a smile on his face.

In fact, whether you realize it or not, the U.S. economy has fast become the envy of all the world. There was a 33 percent gain in the Dow in 1995 and a 26 percent gain in 1996. One has to wonder how long the stock market can continue to climb. The Dow started the year at around 6,400 and it has now gained almost 1,300 points, for roughly a 20 percent increase in less than six months. This is the best six-month period since 1987. The Dow is now hovering just below 7,800 at the mid-June mark.

Weak retail sales in May and a small decline in the leading economic indicators in April (the first decline in 15 months) has lead to a rally in the bond market. The yields for the 30-year Treasury Notes were down to 6.69 percent in mid-June, after going as high as 7.18 percent earlier in the year.

Mid-Year Review of 1997

The stock market started the year off strongly with a string of new closing records for the Dow. However, word spread in mid-February that corporate earnings would actually be below expectations this year, which in turn started a gradual decline of almost 10 percent over the next two months, wiping out all the ground gained by the Dow earlier in the year.

The market dropped in late March after' the Feds raised interest rates, but it rebounded in late April, largely due to the hopes that a budget deal could be reached in. Washington. Interest rates were up in late March, but the yields on the 30-year Treasury Note have since fallen almost a half of a percentage point. Good news about the state of the economy had started the rally in the market in Mid-April. The strong rate of growth came as a surprise to many analysts; in fact, the current pace is the fastest it has been 1988.

Unemployment has also dropped to just around 4.8 percent, the lowest it has been in 23 years, when President Nixon was in office. It is widely held that unemployment rates below 6 percent puts pressure on wages, and in turn prices, causing inflation. But despite all the rosy economic data, there are still no significant signs of rampant inflation at this time. Perhaps wages remain stable due to the effect of global competition.

Fed Policy in Review

Federal Reserve Chairman Alan Greenspan started a debate at the end of last year, as to whether or not investors are being unduly optimistic in regard to the stock market. After a very brief slowdown, mutual fund investors again began pouring money into mutual funds at a furious pace ($24 billion in January alone). Small individual stock investors have either ignored Mr. Greenspan's warning, or else they remained unimpressed with his worries of inflated asset values. So far, investors have been resilient in their confidence in the stock market. How will Mr. Greenspan react if stock values continue to climb this year?

The Feds elected not to raise short-term interest rates in their last meeting, and the general wisdom at the time was that they would wait until the July meeting when more economic data would be available.

In the meantime, the bond market has rallied, lowering the yields on the 30-year T-Bill to 6.69 percent from above 7 percent at the end of May. Greenspan appears to be reluctant to increase interest rates in the midst of such a healthy economic recovery. The economy has now enjoyed six straight years of expansion, and surely he does not want to be the one to kill the golden goose by tightening credit. However, he has also proven to be ever vigilant against inflation.

He has continuously warned investors against the danger of an inflated stock market, but investors don't seem to be listening. Mr. Greenspan was even roundly criticized when he raised interest rates in mid-March. Some analysts felt Greenspan over-reacted to reports of mild inflation, and that he may be running the risk of strangling off growth in the economy if he continues to put such emphasis on non-existent inflation pressures.

On the Near Horizon

The next FOMC (rate policy meeting) is scheduled for July 2nd, which is the next chance Greenspan will have to raise short-term rates. The Feds changed rates for the first time in over a year when they raised short-term rates a quarter percentage point in mid-March. That also marked the first Federal rate increase in two years. Historically, the Feds have gone in one direction with a series of incremental moves before again changing course.

There was a lot of speculation earlier in the year that the Feds would need to raise rates three to four times this year in order to tame growth in the economy. In a speech at NYU on May 8th, Greenspan made it clear that he would not wait for "clearly visible signs" of inflation, because then it would already be too late to contain it. He compared a preemptive strike by the Federal Reserve to a vaccination against inflation for the economy.