Bonds: The Economy

The level of interest rates is driven largely by long term inflationary expectations and the growth rate of the economy. We monitor the GDP Core price index as a measure of inflation, and the Index of Leading Economic Indicators (LEI), looking for clues about future economic growth. The LEI consists of 10 different economic indicators.

Let's take a look at inflation. There has been much talk about inflation in the press. We believe we have experienced a cyclical upturn in inflation, but the long term secular trend in inflation is still lower. The response from the Fed during the last 2.5 years has increased our confidence in both their ability and their desire to control inflation. The chart below shows the GDP Personal Consumption Core Price Index from 1992 to 2006. Also graphed on the chart is a 13 quarter moving average, which shows the smoothing of the index over a three year period. Bernanke has said that he would like to see this index under 2% as an upper band. It is currently 1.9%.
Economic growth depends largely upon the availability of credit. A good measure of the tightness of credit is the slope of the yield curve. Our economy has had an inverted yield curve since last June. An inverted curve is like a tourniquet on the economy. The lifeblood of the economy is money, and the Fed is restricting the ability of different sectors to have access to credit. The economy is gradually showing signs of weakness as the restriction of the "blood flow" to the economy affects different "body parts" more quickly than others. The chart below is for the interest rate spread between a 10 year treasury and fed funds. It shows the dramatic change in the yield curve that has taken place since the Fed began tightening in June of 2004. Banks are in the business of borrowing "short" and lending "long". When the yield curve is inverse, the economic incentive for them to loan money is reduced because they can't make money off the trade of borrowing short and lending long. This also helps to restrict the availability of credit, and helps to dampen the economy.
Perhaps the first body part to experience distress was housing. The weakness in housing is illustrated by the rapid decline in building permits which began their decline in the last quarter of 2005.

New orders for consumer goods are also showing weakness. This component in the index of leading economic indicators is an inflation adjusted value of manufacturers new orders for consumer goods and materials, and is designed to lead changes in production. This index peaked out in the middle of 2004 when the Fed began tightening credit.
The weakness in housing is now spreading to sub-prime mortgages. There is weakness in risk assets such as domestic and foreign equities, and in commodities like gold and oil. The question being asked now is, "will this weakness spread to other areas of the credit markets?" The answer is clear. The economy will continue to slow until the Fed realizes that it is about to kill the patient, and then they will ease up on rates to try to get things going again. This is a very favorable environment for bonds. We believe that current bond rates are attractive, and investors who are still bearish should rethink their positions.