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Monday, July 31, 2006

The Economy, Bonds & Interest Rates

By Yaser Anwar, CSC of Equity Investment Advisors

Bond yields declined for the third week in a row as weaker than expected economic data diminishes the odds of additional Fed rate hikes (2nd Q GDP was reported rising only 2.5%, well below the 3% expected).

According to surveys conducted by ISI Group on a weekly basis, there is the sharp and rapid decline in new home sales expectations, which is not new. The surveys also points to the increasing odds of a hard landing in housing which will echo throughout the economy, since housing has been responsible for alot of the employment.

In a study released last week, the Dallas Fed noted that the fraction of components experiencing annualized increases of more than 3 percent had grown to 57 percent, from 33 percent in December. Prices have risen more in the past three months than in the preceding three months, regardless of whether owners' equivalent rent is included or excluded. A model developed by a Fed researcher puts the odds of a recession occurring in the next year at more than 35 percent.

PIMCO finds that real house prices are pro-cyclical and tend to reach a maximum near business cycle peaks, often after a prolonged period of buoyant growth in activity has raised output above its potential level and inflation pressures have begun to emerge. With the core PCE deflator in the GDP report increasing 2.9%, in line with expectations but above the Fed’s comfort level, could lead to Fed raising rates further.

The bond market is signaling a slowing economy, an impending pause in the Fed's rate hiking campaign and lower bond yields going forward. If the Fed takes rates to 5.75 it will exacerbate the inversion of the yield curve & longer-term be more beneficial to the bond market by further dampening inflation pressures and creating a headwind for the economy.

The credit spreads are also indicating a cooling of in the economy. A slower economy increases credit risk, hence the expansion in the risk premium demanded by creditors.

Real house prices fall for about five years and their previous run-up is largely reversed. Real GDP growth slows during the first year or so after house prices peak as do growth rates of private consumption and investment.

An index of trucking companies sales expectations shows that while the its absolute level is in neutral territory, the index suffered its largest decline in the history of the survey. This is another indicator that the economy is slowing faster than many expect (Pointing to a possible Fed hike sometime soon).

Bond prices usually bottom several months before the last Fed Funds hike as the market begins to anticipate the Fed, which in turn is attempting to anticipate the economy and inflation. With the Fed near the end of its tightening cycle and the economy increasingly looking vulnerable, it may present an opportunity to add some bonds in your portfolio.

Sources: ISI Group, Reuters & PIMCO

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