Economy Gains Steam, Knocking Down Bonds

Updated from 10:38 a.m. EST

When the first quarter began, the economy was pressed hard against the ropes. After seeing it buffeted by a capital spending-led downturn that only intensified in the aftermath of Sept. 11, many reckoned the U.S. might not begin to recover until midyear.

But on Thursday, the last trading day of the quarter, two more reports testified to the swiftness of the economy's rebound.

The final March reading of the Michigan Consumer Sentiment Index came in at 95.7, its highest level since December 2000, against expectations that it would rest at its midmonth level of 95. The Chicago Purchasing Managers' Index rose to 55.7, its highest level since June 2000, up from February's 53.1. Economists had forecast it to come in at 54.

"Clearly we've had a turn in the economic data quicker than anyone was expecting," says Mike Cloherty, bond market strategist at Credit Suisse First Boston.

The two reports neatly show how two main props to the economy, the consumer and manufacturing, continue to improve. Initially stocks improved on the data, though they faded late in the day. Treasuries slipped badly on expectations the Federal Reserve will soon be ratcheting up rates.

'Wrong Zip Code'

Heading into the year forecasters feared that, due to job worries, consumers would pull in their horns. This would further weaken manufacturers, who would need trim jobs even more -- a vicious cycle that would make recovery trying.

Instead, it increasingly appears, consumers kept on spending and manufacturers, who had been bracing for the worst, found they had cleared out their warehouses too aggressively and had to step up production to catch up.

"You could tell from the data we were looking at companies had too little inventory," says Jim Glassman, economist at J.P. Morgan. "A situation like that tells you to fasten your seatbelts." As companies' need to restock became clear, he concludes, he and most other economists realized that their forecasts for weakness "were in the wrong zip code."

Even those few economists who forecast recovery would come quickly have been surprised by its strength. At the beginning of the year, when most economists were expecting contraction, Northern Trust chief U.S. economist Paul Kasriel expected first-quarter gross domestic product to tack on 1.5%. He got the sign right, at least, but it now appears that growth in the first quarter will be somewhere around 5%.

"Quite simply, I was more optimistic because I looked at one of the key components of the index of leading indicators," he says. "I looked at money supply." Through the fall, the nation's money supply grew at a fast clip, as past rate reductions kicked in and as the Fed primed the pump harder in response to Sept. 11. Kasriel says the big reason he didn't forecast a bigger rebound is that he didn't put enough faith in what money can do for the economy. Nobody did.

Bermuda Triangle?

"We were in uncharted waters," says Morgan Stanley economist Bill Sullivan. "We all underestimated the degree of liquidity the that the Fed provided the financial system and how that would ultimately support the economy. We all underestimated the support that would be forthcoming from that big drop in energy prices -- that freed a huge volume of discretionary spending power. We probably didn't correctly assess the impact of refinancing opportunities, which bolstered household cashflow to such a level that people had more confidence to spend."

The only thing that does seem to have accurately predicted recovery, it turns out, may have been the stock market: The benchmark S&P 500 tacked on 10% in the fourth quarter. But tellingly, even as the economy has put on a rebound that has outpaced even the biggest bulls' dreams, the S&P ended the first quarter flat with where it began.

Maybe that's a forecast that growth is going to moderate in the quarters to come. Or maybe it just tells you that stocks are valued so richly that even stellar economic growth isn't enough to make them budge.

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