Discounting the Coming Production Boom

This blog post originally appeared on RealMoney Silver on June 11 at 6:57 a.m. EDT.

A second-quarter "growth scare" bursts the bubble in the government bond market. ... The U.S. economy stabilizes sooner than expected. After a decidedly weak January-to-February period (and a negative first-quarter 2009 GDP reading, which is similar to fourth-quarter 2008's black hole), the massive and creative stimulus instituted by the newly elected President begins to work. Banks begin to lend more aggressively, and lower interest rates coupled with aggressive policy serve to contribute to an unexpected refinancing boom. By March, personal consumption expenditures begin to rebound slowly from an abysmal holiday and post-holiday season as energy prices remain subdued, and a shallow recovery occurs far sooner than many expect. Second-quarter corporate profit growth comfortably beats the downbeat and consensus forecasts as inflation remains tame, commodity prices are subdued, productivity rebounds and labor costs are well under control. ...

The yield on the 10-year U.S. Treasury note moves steadily higher from 2.10% at year-end to over 3.50% by early fall. ... Foreign central banks, faced with worsening domestic economies, begin to shy away from U.S. Treasury auctions and continue to diversify their reserve assets. By year-end, the U.S. dollar represents less than 60% of worldwide reserve assets, down from 2008's year-end at 62% and down from 70% only five years ago. ... Importantly, China not only is no longer a natural buyer of U.S. Treasuries but it is forced to dip into its piggy bank of foreign reserves, adding significant upside pressure to U.S. note and bond yields.

-- Doug Kass, 20 Surprises for 2009 (Dec. 28, 2008)

Six months ago The Edge's 20 Surprises for 2009 suggested that a second-quarter economic growth scare would serve to move interest rates to substantially higher levels than existed at year-end 2008 and to levels higher than was generally expected.

The recent rapid rise in interest rates has been right on cue, and it seems that almost regardless of "real" final demand, second-, third- and even fourth-quarter economic growth will exceed the expectations that existed only a few months ago.

While I am of the belief that my expectations of a "production boom" (importantly, not an investment boom) over the balance of this year will be short-lived and will presage a double dip in the economy sometime in 2010 (as the consumer continues to save and personal consumption falters), the drawdown in wholesale inventories has been extreme and casts in stone improving economic statistics over the next few months.

Courtesy of ISI

A near-term production boom should feed into better readings for ISM and for the labor markets over the next few months. It could also continue to lift the "animal spirits" and buoy confidence in the equity markets at the expense of the fixed-income markets.

Or maybe the recent rise in stocks and in bond yields has already discounted the second-half domestic economic recovery, and traders will be more forward-looking in recognition of the substantive nontraditional headwinds that will come to the fore in 2010.

Indeed, it is my vote that the capital markets have already discounted the imminent (but relatively short-lived) production boom I am projecting and that it is too late to buy stocks and sell bonds.

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