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Neither the Fed nor the Dubai Royal Family Are Finished – A National Perspective of the U.S. Economy

Posted by admin on May 4, 2012
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The Following Article is from the Spring 2006 Newsletter

The bond markets have fallen sharply as news of robust employment growth and increasing inflationary pressures have increased the probability that the Federal Reserve could extend its tightening cycle.  The Fed in late March raised its key overnight target rate another quarter of a percentage point, to 4 ¾%, extending to 15 its latest series of quarter-point rate increases.  Furthermore, it is increasingly certain of yet another rate boost by May, which would bring the fed-funds target to 5%. 

Is a major shift underway now that we have an inverted yield curve with short rates higher than long rates?  In late February we first saw this occur when the yield on the two-Year Treasury securities closed at 4.73%, while the yield on the 10-year note stood at 4.56%; resulting in a 17 basis point inversion in the yield curve.  However, there are fundamental reasons that the long rates are now tracking the ascent of the short rates. 

With the continuing tightening of monetary policy, the potential exists for the creation of a significant drag on the economy’s momentum. This slowdown may be especially felt in the housing sector later in the year and into 2007.  Historically, a yield-curve inversion almost always precedes a recession, as the rise in short-term rates above longer ones inhibits lending throughout the banking system.   On March 24, the yield on the two-year Treasury note, the maturity most sensitive to moves by the Fed, closed at 4.764%, while the yield on the benchmark 10-year note stood at 4.737%, (a difference -2.7 basis points between the 2-and 10-Year Treasury) moving to a flattening of the Treasury Yield Curve through an upward shift in long rates.  Long termU.S.interest rates are now at a three year high. (See Index Chart)

Why the push towards higher long rates?  Simply stated, the Fed is on a targeted measured path to remove some of the excess liquidity in the economy. U.S.consumers have been resilient and have driven strong sales for housing, autos and other goods and services.  Fed actions may not prove to be prudent given that most of the economic strength is based on consumer spending, not business investment. 

In addition, foreign business investment may begin to slow because of protectionary concerns arising from theUnited Arab Emiratesfall out from the port deal.   The list of U.S.businesses owned by Arab investors – not just fromDubai- includes some well-known names. Among them are Caribou Coffee Co., the fast-growing rival to Starbucks Corp.; Church’s Chicken, a fast-food concern; Loehmann’s, a specialty clothing retailer; TLC Health Care Services Inc., a provider of home nursing and hospice care; and even several financial publications, including the American Banker.  Foreign capital is critical to the U.S.economy, as off-shore investors now own almost 50% of all outstanding Treasuries.  Our interest rates would increase sharply if these investors were to start dumping their U.S.securities.

Finally, if economic growth is based mostly on consumer spending, what happens if the national housing markets continue to cool into the summer?  You could see investors shifting more capital into the stock market again, instead of real estate.  Housing appreciation could slow, which means less borrowing based on home asset equity.  Borrowings would shift to more personal loans, such as credit cards with their higher interest rates.  Something IS going on!  Consumers are spending more and saving less than they were just a few years ago.  In fact, the net savings rate is the lowest since the depression! 

There continues to be concern that the achievement of a 5% Fed-Funds target will over shoot and slow the economy too much.  As such, the Fed may very well need to change course and lower rates by the end of this year.  The predicament is that our economy cannot withstand sharply higher rates in a short span, as it is largely finance-based with housing at its epicenter.  With inflation still under control, the Fed may be finished with restrictive monetary policy for the year after the March and May anticipated increases.  If the Fed switches to an accommodative policy later this year, short-dated Treasuries, such as two year notes will benefit most from that scenario. 

Joseph Levy, is the Owner of Affiliated Capital Resources, a mortgage banking firm in Santa Monica, CA.  Mr. Levy received his MBA Degree in Real Estate Investment Finance from University of Connecticut.

The opinions expressed here are strictly those of AFFILIATED CAPITAL RESOURCES and are subject to change without notice. AFFILIATED CAPITAL RESOURCES is a mortgage banking firm which advises accounting and business management firms pertaining to residential and commercial real estate financing services for their clients. DRE License No. 01125517

Click Here to download the entire Spring 2006 Newsletter

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