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ALM
First Financial Advisors
Economic Overview
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UPDATE -
Third Quarter 1998
TOPICS
COVERED
Introduction
As we close the third quarter we find the Fed in
a difficult position. As we will investigate later in this
review the US domestic economy is still thriving, producing
very low unemployment coupled with low inflation. This represents
an attractive environment for the capital markets and its
participants. As most would agree the US economy and its stability
is the Fed's overriding priority and would argue for stability
in the Fed's main monetary supply mechanism, the Fed Funds
rate.
 However,
surrounding our domestic environment of prosperity is a chaotic
frenzy of panic selling in currency markets and foreign economies
coupled with a lack of leadership coming from governments.
This has impacted the investment psyche with the threat of
impending doom.
This has
done a fair job of spooking our equity markets, which has
made short time in shaving off 20% in market value from our
most recent high.
The dilemma
facing the Fed at this time is should they hold the Fed Funds
rate steady in the face of record low unemployment and job
creation, or should they calm the equity markets and its'
possible impact to the national psyche by easing more than
the token 25 basis points cut at the last FOMC meeting?
Some argue
loudly that the absence of any inflation gives the Fed room
to ease to combat fears developing for profit margins and
overseas sales. This viewpoint coupled with the rush to safe
havens from foreign investors, the US Treasury market, has
pushed the yield curve down into an inverted shape and to
yield levels unimaginable just two months ago.
This
Quarter's Numbers
The yield on the two-year Treasury Note moved lower during
the first half of the 3rd Quarter as projected by our last
Economic Review on the basis of currency dynamics. The yield
moved briskly to the low 5% area. Then during the last half
of August we experienced great turmoil overseas with the culmination
occurring in Russia where the Ruble was devalued and the government
basically nationalizing billions of dollars raised just weeks
prior to the devaluation. And then the Japanese cut their
overnight rate in half from 0.50% to 0.25%.
The Russia
situation by itself is not too alarming to us. In fact the
economy in Norway is more significant on the world stage than
that of Russia. If Norway would have devalued its currency
by 30% I am certain that it would have hardly been registered
in the national press. The risk that Russia poses is that
instability in a country with its military destructive power
is unsettling to us.
This development,
coupled with the new revelations at home that threatens the
Clinton Administration as a going concern, have fueled the
fire of uncertainty. These actions have raised the bar on
Treasury prices and decreased yields on the two-year Note
to 4.00% today.
Domestic
Economy
Consumers continue to lead the expansion. Housing starts and
sales are at a ten-year high. Home ownership costs as a percentage
of income are the lowest in post-war history. As predicted,
these indicators have begun to show signs of weakening.
As more
and more people have felt the benefits of the strong stock
market, consumer perception becomes very important. This is
what concerns the Fed.
Consumer
confidence, as measured by the Conference Board, reached a
new high in June and will be a key determinant to future activity.
The latest monthly indication shows a decline from the high.
The continued bad news emanating from Wall Street and Washington
will continue to place a drag on confidence.
The labor market continues to be very tight. The May unemployment
rate was the lowest level since 1970. Employment growth continues
to average 250,000 jobs per month. Many economists believe
that the labor force growth is one of the major surprises
in this economy, reflecting more immigration and higher labor
force participation rates.
Weak fringe
benefit growth and declining import prices are offsetting
higher wages to limit the impact on prices, however.
The percent change in both the CPI and PPI continues to be
small, a signal of very little inflation.
 The
two primary constraints on the U.S. economy are the tight
labor markets and the high level of inventories.
In summary,
the U.S. economy continues to look strong and healthy. There
are some early signs of an economic slowdown, however. As
mentioned in the introduction, neither the economy's strength
or the indicators of a slowdown are major factors in the forecast
of the current quarter. Over the next six to twelve months
however, we continue to believe that the economy will trend
lower and catch up to the low rate environment dictated by
the market place.
Yield
Curve
The second quarter was characterized by more good news about
the federal budget and hence a more flat yield curve. As mentioned
in last previous review, a possible yield curve inversion
is a concern for financial institutions when the curve is
this flat. An inverted yield curve would have a major impact
on net interest income.
Today,
we find ourselves with an inverted curve originating with
the Fed Funds Rate. Today the Fed Funds rate at 5.25 % yields
considerably more than the 30 year Treasury bond.
Historically,
both rising short rates and bearish short-rate expectations
have been required for the yield curve to invert. This has
not been the case in this cycle. The current inversion has
occurred primarily as the federal budget and the outlook for
anticipated inflation has improved coupled with a flight to
quality from overseas and uncertainty at home.
Traditionally,
an inversion would occur once short-term rates had risen enough
to slow growth. This would diminish the effects of inflation
and other risk premiums that contribute to a positively sloped
yield curve. This, in turn, leads to expectations of lower
long-term rates, causing the curve to invert.
We see
a decrease in short-term rates on the horizon and therefore,
do not predict much more of an inversion, but a steepening.
Asia
Two aspects of the Asian crisis are having an impact on U.S.
interest rates. First, the flight to quality issue brings
a lot of foreign investors worried about economies in their
own countries to the U.S. market. Second, the strong Dollar
and potentially weakening Yen makes investing in the U.S.
very attractive to Pacific Rim investors.
Both of
these aspects of the Asian crisis increase the demand for
U.S. Treasury securities. The supply of Treasuries is already
low due to growing tax revenues and the shrinking budget deficit.
A significant increase in demand coupled with this reduced
supply would drive Treasury prices higher and yields lower.
The July
12 election and resultant loss by the ruling party in Japan
adds to the instability of this situation. The prospect of
an entirely new government in Japan increases the chance that
no new government programs will be enacted in the near future
to tackle their economic problems. There is a fear that the
government will go through a stage of policy paralysis during
the transition period.
A perceived
inability of Japan to put its financial house in order would
aggravate the Asian recessions and make the spillover from
Asia worse than expected. U.S. firms would then experience
serious declines in their overseas business, leading to layoffs
and a decrease in consumer confidence. This scenario along
with the increased demand for safe U.S. securities has pushed
rates down considerably.
3rd
Quarter Forecast
Our analysis of the current domestic economy alone leads us
to believe we are currently at the bottom of the trading range
for the two-year Treasury, depending on what happens to the
President. Should his troubles develop to a point of a lack
of significant support from his own party, we suspect that
his Presidency will be over. This may cause some instability
in the Dollar but in the long run contribute to further decreases
in Treasury yields.
In addition,
over the next six to twelve months, we believe that the domestic
economy will experience slower growth and stable term rates
at their current low level. We expect several easings of overnight
interest rates during the 4th Quarter of 1998 and 1999. As
a result we expect to see the Fed Funds rate at 4.50% by year-end
1998 and possibly as low as 3% by year-end 1999.
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