Bond Expert: Wednesday Outlook

Includes: BIV, TLO
by: John Jansen

Prices of Treasury coupon securities are posting small mixed changes in overnight trading. In fact some benchmark prices were unchanged while others posted small declines.

Ebullient sentiment in the equity market is still weighing on the bond market. Goldman Sachs (NYSE:GS) posted better than expected earnings, as did Johnson & Johnson (NYSE:JNJ) earlier. After the close yesterday, Intel (NASDAQ:INTC) reported that Q2 revenues would beat forecasts. So all is well with the equity crowd. For now.

If I may digress from my normal morning musings - it is hard to paint a sanguine portrait of future economic growth.

In the short run it is certainly possible to conjure up a picture of positive growth in Q3 and/or Q4. Inventory levels are low and will be replenished. In particular the automobile industry is set to ramp up production after a period of very low production. That will certainly give a healthy boost to GDP.

I do not see, though, how growth can be maintained at robust levels. Yes, the actions of policymakers have averted financial collapse and Armageddon. However, it is my opinion that the return to 3 percent growth which prevailed for most of the last three decades is most unlikely.

Unemployment (the lagging indicator) will continue to rise and will probably top out close to 11 percent. That does not count the discouraged workers who have left the work force or those forced to work reduced hours at lower wages.

It will be a very slow recovery in the jobs market, as the high level of unemployment will weigh on income growth and consequently spending. Without robust consumption, corporate profit growth will prove anemic and business investment spending by the corporate sector will suffer.

Consumer balance sheets have shrunk as housing prices have cratered and as equity markets have suffered severe declines. Consumers have responded logically by shoring up their balance sheets with increased savings rate. I believe the last savings rate I observed was 6.8 percent (driven there by some one-time factors). For years during the credit-driven expansion it ran around zero.

I am not smart enough to know where it will settle in, but if it does finally settle in around this level it will represent an enormous amount of foregone consumption. If it is not replaced, the long term consequences for growth are quite melancholy.

Government policy is currently stimulative but one can see the shift coming. I note the press reports that the House version of the plan to nationalize health care will include a surcharge on the earnings of millionaires. That is another nail in the coffin of spending.

And at some point several years down the road ( I suspect,) the financial markets will call for a healthy retribution for our profligate spending and in so doing will force additional rounds of tax hikes, which can only be effective at raising revenue by reaching deep into the middle class brackets.

That does not bode well for growth over the long term either. Nor does the carbon tax, which will raise the cost of everything from soup to nuts.

I see a bleak five-year period with growth in the one percent to two percent range. That will provoke a clash between domestic political pressures (too high an unemployment rate) and international pressures to curb deficits, which I suspect will eventually weigh on the dollar and its status as the world reserve currency.

The yield on the 2 year note is unchanged at 0.94 percent and the 3 year note yield is unchanged at 1.47 percent. There is some indigestion in the belly with yields rising in that sector. The yield on the 5 year note has climbed a basis point to 2.37 percent. The yield on the 7 year note has edged higher by 2 basis points to 3.05 percent. The yield on the 10 year note has climbed a basis point to 3.48 percent and the yield on the Long Bond is unchanged at 4.38 percent.