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Jewish World Review Feb. 10, 2000/ 4 Adar I, 5760

Lawrence Kudlow

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Bush's Footprints -- Treasury bonds over the past year or so have been mugged, beaten, trashed, horsewhipped, carpetbombed, murdered and, well, you get the picture. They have become the orphaned stepchildren of the financial community.

Nobody wants them. Stocks have soared, T-bonds have sunk. Not even predictions of massive Federal budget surpluses and Treasury buybacks have helped bonds.

So, is there any hope for bonds? I believe there is. Judging by the inverted yield curve, which probably signals a peak in the rate of economic growth, a modest bond rally may have already begun.

Looking back, over the past fifteen months bonds have been caught in a crossfire between rising real interest rates and rising oil prices. Underlying inflation has never been the issue. Average gold in 1999 was actually lower than 1998. King Dollar remains on his throne.

Looking ahead, oil prices should unwind significantly, and real rates modestly. Also, real economic growth, which registered 4.2% from the end of 1998 to the end of 1999, is projected to ease to 3.2% in 2000 and 2.2% in 2001.

Now, between the fourth quarter of 1998 and January, 2000, 10-year Treasury yields have climbed to an average 6.66% from 4.66%, a 200 basis point rise. Nasty bear market. Partitioning this rate rise into two component parts, roughly 65 basis points can be attributed to rising real interest rates and about 112 basis points can be traced to the temporary oil shock. The remaining 25 bp's can be chalked up to Fed tightening threat jitters and a teensy weensy developing credit crunch (according to Victor Canto). First, the real rate increase is mainly a response to the rise in technology-driven investment returns generated by the Internet economy over the past few years. Remember Irving Fisher's paradigm that nominal rates are the sum of the real rate plus expected inflation. Ludwig von Mises also wrote extensively on this.

The increase in the real rate component of the market rate is one reason why stocks have rallied while bonds have plummeted. Think of it as a real growth premium. Higher real interest rates in this context reflect improved productivity and profits, just what the equity doctors prescribe. Investors are going for growth. And they are downplaying outdated old economy price-earnings ratios.

Also, higher real rates reflect diminished inflation. The core consumer spending deflator has dropped to a 1 1/2% pace in recent years, down from 2 1/2% in the mid 1990s and 4% earlier in the decade. As Nobelist Robert Mundell pointed out in his seminal book "Monetary Theory," unexpected inflation declines lead to rising real rates.

Few people (other than supply-siders) believed that strong growth would generate diminished inflation. But it did. More money chasing even more goods. So real rates have adjusted upward. It's the exact mirror image opposite of the 1970s, when unexpected inflation drove real interest rates below zero.

Then there's the oil effect. For whatever reasons, bond rates are exceedingly sensitive to rising oil prices. Perhaps it's a hangover from the 1970s, or even the 1990 Persian Gulf War. Folks know the oil shock can't last, but bond traders still live in fear and trembling when it happens.

Since late 1998, average crude oil prices have jumped to over $27 bbl from nearly $13 bbl, an increase of 112%. Noteworthy is the 81% correlation between Treasury rates and oil prices. Don't ask me exactly why; it just is.

Adding the 112 basis point rise of oil prices to the 65 basis point hike in real interest rates gets to a 177 basis point rise in the nominal yield on 10-year Treasuries, explaining 88% of the bond rate increase. Pretty neat fit. And just plausible enough to grab my attention.

Now, when Texas Gov. George Bush told the New Hampshire debate Wednesday night that if he were president he'd pick up the phone and jawbone OPEC to raise production and lower prices, he just might be on to something. As you may recall, in 1996 Bill Clinton dissed Bob Dole by stealing all the good Republican ideas (capgains relief, welfare reform, balanced budget).

In the 2000 election that is now heating up, it wouldn't surprise me if President Clinton got on the phone to OPEC just in order to steal a good Republican idea. Maybe even send Defense Secretary Bill Cohen for punctuation. (Sort of like his Republicanesque $350 billion tax cut proposal announced in last night's State of the Union speech, though these are government-directed tax credits, which are really spending add-ons, not free economy marginal tax-rate reduction.)

The U.S. has considerable leverage with Saudi Arabia and Kuwait, including mutual defense treaties, military sales at concessionary financing rates and other assistance. Were it not for the U.S. Gulf War effort, there probably wouldn't even be an independent Kuwait or Saudi Arabia today. And let's not forget that we bailed out Mexico's keister five years ago.

What's more, not even a monopoly cartel can defeat competitive market pressures. You can't sell something for $30 bbl that costs, at the marginal average, only $10 bbl to produce. Consumers will substitute natural gas for petroleum, and battery fuel cell technologies will be rolled out sooner. BTU efficiencies will continue to rise in our service economy.

My hunch is that presidential persuasion and market forces will pull oil down toward $18 to $20 bbl. This could take about 50 basis points off the Treasury bond rate, bringing it back toward 6%.

As for real interest rates, I think the combination of Fed restraint (total bank credit growth has already slowed to 5% from 11% according to Victor Canto) and slower post-Y2K technology investment and production will take some of the sizzle off the economic grill.

Already, computer-makers such as Dell, Compaq and Gateway are reducing their sales revenue estimates for 2000. Some of this reflects a shortage of computer chips, but the boxmakers also anticipate a post-Y2K spending lull. Meanwhile, consumer cyclical and consumer staple stocks have been steadily underperforming over the past six months, according to West Coast economist Scott Grannis.

What's more, as consumers began to sense higher interest rates last summer (mortgage rates shot up, and cult-figure rock star Greenspan's tightening message was clear), they stepped up purchases to beat even higher rate moves in the future. But some of the nearly 6% growth of last year's second half was borrowed from this year's spending. So economic growth in 2000 is likely to moderate to around 3 1/4%, a downshift from the 4 1/4% trend of recent years.

Also, fed funds rate changes affect economic growth (though both the magnitude and the timing are mysteriously unclear). Three funds rate declines in the second half of 1998 raised second half 1999 economic growth by nearly a percentage point (5.7% in 1999 v. 4.8% in 1998). With three rate hikes in 1999, the 2000 economy will surely slow. If there are three rate hikes in 2000, then the 2001 economy will slow even more.

Consequently, look for a more normal real interest rate of around 3 1/2 % to 3 3/4%, representing a gradual descent of perhaps 70 basis points. This could move 10-year Treasuries down to 5 1/2%. Another way to see this: 3 1/2% real rate plus no more than 2% expected inflation equals a 5 1/2% bond yield.

Barrring yet another oil uprising, the current yield curve inversion pulling 30-year bond rates below the 2's, 5's and 10-year rates may well be a harbinger that the worst in bondland is over. In fact, I suspect the negative-sloping curve is also signaling an oil peak.

Another moral of this story. There's still room for presidential leadership, even in the Internet economy. Even lame ducks can still quack. And G.W. Bush's footprints may already be sinking in.

JWR contributor Lawrence Kudlow is chief economist for Schroder & Co. Inc and CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.


01/25/00: To preserve its standing as the world's number one economic power
01/06/00: It's not the '70s
12/28/99: They missed it
12/23/99: Bonditos
12/20/99: Dracula's Curve
12/16/99: When Alan Greenspan sneezes, Wall Street economists catch cold
12/10/99: Y2K-Related Cash
11/23/99: Y2K Money: Inflationary or Not?
11/16/99: Investor Retaliation
11/05/99: Rosy Lives
10/29/99: Drain Reserves
10/22/99: Supply-Side Is Mainstream
10/14/99: Y2K will likely bring more prosperity
10/07/99: Clinton's tax-cut veto
10/01/99: What's really bugging the stock market?
09/23/99: Growth Trade
09/09/99: Bad Dollar Logic
09/09/99: Buttered bread
08/31/99: Bull Market Alive and Well
08/26/99: Let Prices Rule
08/19/99: Blame OPEC, Not Growth

©1999, Lawrence Kudlow