Fear of A Strong Economy, Again

By Duru

August 7, 2005

 

The quick trigger fingers were on open display after Friday's strong jobs report spooked the bond market. The conventional wisdom I am reading is that the jobs report sounds inflationary, and the strength it shows will convince the Fed to keep raising rates well beyond the window most folks were hoping for. Now, why the surprise? I still cannot understand. I have never bought into the growing hopes folks have had for an imminent retirement to the rate-hiking campaign. In fact, a few months ago, I clearly pointed out that the Fed has gotten dead-serious about fighting inflation. It is quite ironic that the Fed has nailed things right on the head this time: the economy is quite strong and doing well. Even the dollar of late has been handing out a beat-down to the Euro. Given that the economy can absorb much higher interest rates than we have now. Look how well the economy has absorbed ever high oil prices and the prices of many other commodities. Indeed, the continued strength in the housing market given the continued stubbornness of long-term yields compels the Fed to keep hiking those short-term rates up and up. A smart player will forget about trying to predict the end of this campaign and instead focus on the market's reaction to events as they unravel.

The jump in long-term rates (the 10-year bond leapt a huge 7 basis points) means that we have gotten that much closer to the supposed day of reckoning in the housing market. Lost in the buzz about the dire consequences is that these rates are still below the levels we saw right before the market bottomed for this year. These rates are not even close to those seen at the peak of bond yields in 2004. Certainly, there is a short-term trend up in rates, but longer-term, you would be hard-pressed to make a convincing case for an up-trend. (I strongly encourage you to take a look at the charts by clicking the links for the Yahoo charts. If I get time later, I will post my own.) Wachovia threw its hat into the bearish ring by issuing a downgrade to one of the top homebuilders, Toll Brothers (TOL). Part of their downgrade from market outperform to market perform (oh the horror to only perform as good as the rest of the market!) referred to some potential weakness in Washington, D.C. It just so happens that this market represents about 23% of Toll's business. The angst over trying to get ahead of potential weakness based on the performance of one market reminds me of a similar scare that we saw in Pulte Homes when the bubble took a break in one of their larger markets - Las Vegas. Until someone produces credible evidence of more systemic weaknesses, I suspect that the ensuing scare will provide a buyable dip - even if it is for a short-term trade.

Now, do not worry. I am not suddenly adopting the hubris that so many still have in the housing sector. Note well that housing has become an extremely important component of America's economy. On Nightly Business Report this past Friday, James Stack, President of InvesTech Research, claimed that 40% of all jobs created in this recovery have been related to real estate in some way. We all know what happened when speculation in high-tech consumed a disproportionate amount of economic activity, and the Fed must be nervous about our latest bubble. While Greenspan has proven ill-equipped to managing over-heated economic activity, I expect he and the rest of the Fed to tread carefully (though with determination) in trying to cool off the housing sector.

In the meantime, I actually remain relatively bullish on the market as a whole. We should expect a sharp correction in reaction to Friday's news and to any hawkish comments from Greenie next week, but I suspect that after the market realizes that nothing has fundamentally changed, the rally for 2005 will pick up again. The last time I noted the market's fears over a strong economy in April of 2004, the market promptly fell steeply for about a month before bouncing back just as sharply. After a continued campaign of interest rate hikes, we are now 6% higher on the S&P. This run is all the proof we need that economic activity remains robust all things considered. But make no mistake about it, there is not likely a whole lot of breathing room left at these heights. So, as always, be careful out there!

 

DrDuru, 2005