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Before Rates Can Descend, Serious Obstacles Remain

Was last week’s second-quarter economic growth report the kickoff for a major drop in interest rates--or just the bond market’s version of “True Lies”?

Bond yields plummeted Friday after the government stunned Wall Street with a 3.7% estimate of real economic growth in the second quarter.

Some economists thought the second-quarter number would be 5% or higher. Moreover, few pros guessed the extent to which inventory buildup--as opposed to final sales of goods--would factor into the growth number.

Donald Straszheim, economist at Merrill Lynch & Co. in New York, says that “well over half (the second quarter’s growth) resulted from an unsustainable surge in inventory building,” particularly at the wholesale and retail level.

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If the goods are on the shelves, but they’re not moving (or are moving slowly), the assumption is that production will have to be restrained this quarter until sales catch up.

Ergo, a weaker economy, weaker inflation potential, and a chance for interest rates to pull back--benefiting the stock market, bond owners, home buyers and a host of other constituencies.

Not so fast, some Wall Streeters warn. Despite Friday’s bond rally, which sliced the yield on the benchmark 30-year Treasury bond from 7.55% to 7.39%--the lowest since June 16--three high hurdles stand in the way of a significant drop in interest rates from here:

* A barrage of economic indicators. This week, markets face seven major reports on June economic activity, including construction spending, new home sales, leading indicators and consumer credit. And on Friday, investors get their first important look at July activity, with the release of the monthly employment report.

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While the second-quarter gross domestic product report included many convincing elements of a slowdown, Wall Street will want to see them confirmed in June numbers, and definitely in the July employment data. Otherwise, the GDP report will begin to look like Schwarzenegger’s “True Lies"--where nothing is quite as it seems.

One warning for would-be bond bulls: Last Wednesday’s report on June durable goods orders was twice as strong as expected. Everybody seemed to forget that Friday, with the GDP number.

“I think we’re coming into the second half at a pretty good clip,” argues David Jones, economist at bond dealer Aubrey Lanston & Co. in New York. Booming corporate profits, he says, should mean continued high business spending on plant and equipment. And a pickup in growth in Europe and Japan should boost U.S. exports, he adds.

* A cash-needy Uncle Sam. The Treasury will announce details this week of its “refunding,” the quarterly borrowing binge that will take place next week. The government is expected to raise $40 billion in auctions of three-year notes, 10-year notes and 30-year bonds, consecutively starting Aug. 9.

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With that heavy supply ready to hit the market, some potential buyers may hold back this week--especially after Sunday’s White House decision to launch trade sanction proceedings against the Japanese.

The worsening trade row may guarantee that Japanese investors, who once vacuumed up T-bonds by the billions, will remain on a “buyer’s strike” as far as U.S. securities are concerned.

And if the dollar plunges anew because of the trade decision, the bond market could be swamped with selling by Japanese and other foreign investors who fear their U.S. assets will suffer another severe round of devaluation.

* Uncertainty about the Fed’s next move. The bond market’s rally Friday, and particularly the steep drop in short-term T-bill yields, suggested that investors no longer believe that the Federal Reserve Board will tighten credit soon. Why should the central bank raise short rates again if the economy is indeed slowing?

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The yield on three-month T-bills, which rose steadily from 4.34% on July 18 to 4.54% by last Thursday as the market assumed another Fed rate hike was coming, plunged to 4.37% on Friday.

*

But when the Fed’s policy-making committee meets on Aug. 16, the surprise may be that Chairman Alan Greenspan & Co. decide to tighten credit anyway, some economists warn.

Louis Crandall, chief economist at bond firm R.H. Wrightson & Associates in New York, believes that the Fed has succeeded in dampening economic growth with its four official rate increases since February.

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But now the central bank’s focus will turn exclusively to inflation, Crandall says. And he thinks there’s enough inflation in the pipeline--thanks to three consecutive quarters of healthy growth--to compel the Fed to boost short rates even higher as an anti-inflation tonic.

Despite the arguments that the second quarter’s inventory buildup augurs price cuts rather than price increases, Crandall says that inflationary pressures often lag GDP growth, like mushrooms after a rain. Businesses “are just a lot more optimistic now about their ability to raise prices and make it stick,” he says.

He figures that will mean that monthly increases in the consumer price index, which have been running at 0.2% to 0.3% for the past year, will pick up to 0.2% to 0.4% in the second half of this year.

“The first time we get a 0.4% (monthly rise in the) CPI, that’s going to be a very negative development for the bond market,” Crandall warns. The July CPI report is due on Aug. 12.

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Notably, even as inventories grew in the second quarter, the GDP implicit price deflator, a key measure of inflation, rose at a 2.9% annualized rate--the same as in the first quarter.

Robert Brusca, economist at Nikko Securities in New York, agrees that the Fed is likely to feel pressure to tighten again because of latent inflation concerns. Compounding the problem, he says, is that U.S. worker productivity is declining this year while many commodity prices are rising--a dangerously inflationary mix.

“I think the Fed is going to be very worried” about that trend, Brusca says.

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And yet, Brusca believes that long-term bond yields, if not short-term yields, could still be primed to ratchet lower between now and year’s end.

Even if the CPI growth picks up from its 2.5% annualized rate in the first half to between 3% and 4% in the second half, the current 7.39% yield on 30-year Treasury bonds represents a historically high return relative to inflation, Brusca notes.

“I think the bond market has just gotten too pessimistic” about the longer-term outlook and is overdue for a turnaround, he says.

Indeed, overly bearish sentiment in bond and stock markets could mean that August’s surprise will be a lightning-fast rally that drives bond yields down and stock prices up, assuming the economic data cooperate and the Treasury’s refunding goes OK.

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In the stock market, “short” sales--the amount of borrowed stock sold by bearish traders anticipating further price declines--are at record levels. A rally in bonds, however brief, could force many stock short-sellers to cover their positions, fueling panicked buying of shares.

But the sustainability of any market advance is questionable, especially in bonds. If you assume that the economy picks up again in the fourth quarter, or early in 1995, renewed jitters about interest rates and inflation won’t be far behind.

R.H. Wrightson’s Crandall continues to recommend that clients sell into any bond rallies. His rule of thumb for traders: Buy bonds when the 30-year T-bond yield is above 7.5%, and sell when it falls below 7.5%.

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A Turn for Wall Street? The stock market didn’t respond all that well to Friday’s big drop in bond yields. The Dow industrials added just 33.67 points to 3,764.50. In contrast, when the T-bond yield plunged from 7.44% to 7.26% last May 17, the Dow mustered a 49.11-point gain.

Still, the market did manage to rise in July, which may come as a surprise to investors who got bored with the lethargic trading action. The Dow jumped 3.8% for the month, the Standard & Poor’s 500 index gained 3.1% and the Nasdaq composite index added 2.3%.

Curiously, on Friday, the market leaders were industrial issues such as Clark Equipment, up $1.50 to $68.75, Dow Chemical, up $1 to $69.125, and steelmaker LTV Corp., up $1.625 to $18.75--all of which traded at new ’94 highs.

If the economy is on the verge of a major slowdown, you wouldn’t expect stocks of commodity producers like chemical and steel companies to be surging. Either buyers of those stocks are in for a rude shock, or the economy’s pace--and the longevity of this expansion--are better than the second-quarter GDP report might suggest.

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