A Braking U.S. May Still Get Pushed by Accelerating Global Economies

The strength of recent and coming reports is likely force the FOMC to act, but the most important issue is how foreign exchange will respond.
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Meteorologists and market mavens have had to deal with unpleasantly hot conditions during these past two weeks. In a grotesque imitation of March's weather pattern, U.S. equity markets in July came in like a lion but went out like lamb chops.

The early-July roar developed when investors apparently concluded that the

FOMC's

removal of its tightening bias, in the wake of its having hiked the Fed funds target to 5.0% on June 30, meant that it was once again safe to reach out for duration. Both stocks and bonds rallied over the course of the first two weeks of July as investors did just that. But it's been ugly ever since.

The hawkish tone of the midyear

Humphrey-Hawkins

report caused investors to reconsider. Speaking of imbalances, skewed risks and the possible need for "prompt and forceful" reaction on the part of the

Fed

,

Alan Greenspan

set the markets up for substantial volatility around reporting dates for labor market and inflation data.

Last week's quarterly

Employment Cost Index

was both labor market and inflation data at one and the same time. It seemed to print right in Greenspan's face -- to be almost a direct challenge to him, and therefore to market

sang-froid

. Both wages and salaries and employee benefits components surged well beyond consensus expectations in the second quarter. There was a large element of bounce-back from unusually low labor costs in the first quarter, and the four-quarter rate of change for total compensation still lies below the level it reached prior to last year's global depression fears. But this report had the effects of tilting the expected future direction once again toward the high side and making it much more difficult to imagine that the Fed is done with tightening for the time being.

The

GDP

top-line number printed weak at 2.3%, but I don't know why anyone looks at that now when the important issue is the pace of domestic demand. The U.S. household and business sectors, taken together, have been in an anaerobic sprint: Private domestic final sales have averaged 7.0% at an annual rate in the two quarters prior to the most recent one. A slowdown should not have been a surprise, but the 5.1% second-quarter rate of growth isn't much of a slowdown. Drags from inventory investment, government spending and foreign trade pulled the total rate down, but none of these are central to the U.S. outlook. Given the composition of these second-quarter data, economists will almost surely soon be marking up their second-half forecasts.

In any case, the numbers are likely to come in too strong for the FOMC to avoid being expected by the markets to act on its tough talk. Steepening yield curves and trading in Fed funds futures reveal this expectation. Oil and industrial materials price trends offer no solace, and the merciless heat, while not itself a manifestation of overwrought domestic demand, nevertheless pushes up electricity costs now and cattle and hog prices later.

But the real issue, in my view, is in the foreign exchange markets for the yen and euro. This is where the potential flash points lie. Responding to a question on this topic before the

Senate Banking Committee

last week, Greenspan suggested that this concern is a bit overdone. Would foreigners begin to sell their large holdings of dollar-denominated assets? He replied that he didn't foresee that happening. "I can't say that I've seen anything like that, or anything remotely pending. But it's clearly one of the issues which I think we at the Federal Reserve and my colleagues at the

Treasury

are watching very closely."

To me, that's what he has to say. He can't mention the unmentionable; he can't dwell on the risk of a downturn in the dollar because speaking the name of that particular devil might invoke its presence. So he emphasizes the imbalance in the labor market because you can't call your broker and hit bids in the labor market. But if he highlights the risks inherent in our distended current account imbalance he might set in motion exactly the sort of market adjustment that he fears. And

Larry Summers

, the new Treasury secretary, is another one who must keep more or less mum about forex markets; he has a curriculum vitae that includes academic publications of a dovish persuasion on the dollar. He therefore can be expected to stick to his predecessor's careful mantra: "a strong dollar is in the best interests of the United States."

The current account imbalance creates a chicken-or-egg conundrum for forecasters. Will it close up, as eventually it must, because foreigners choose to invest their capital elsewhere, which will push the dollar down and impel Americans to buy fewer imports? Or, as their economies recover, will foreigners instead buy more of our exports of goods and services, thereby closing the trade gap but turning up the heat under our already hot labor markets? Either of these scenarios might develop in the weeks and months ahead -- the former might happen suddenly while the latter will take time -- and markets (and Greenspan and Summers) will be alert for them. The alternative outcomes -- foreigners buying dollar assets with even greater appetite while avoiding our exports -- actually happened last year, with attendant global depression fears that produced a cavalry charge by the world's central banks. The risks now are skewed the other way.

Hysteresis is a word worth knowing. The spell-checker in MSWord isn't familiar with it but it's an everyday phenomenon. You're third in line at a stoplight. When it turns green, you have to wait for No. 2 to move, and No. 2 has to wait for No. 1; those little lags are hysteresis effects. Or you're towing a trailer and you have to gun the engine to get it moving, to overcome its deadweight inertia. But then when you've got it rolling and you try to decelerate, it gives you a push in the back.

The U.S. economy has been pulling the dead weight of the rest of the world's economies, but it looks more and more like they too have begun to roll now. When our economy decelerates, either of its own volition or through the braking action of the Federal Reserve, it will get a push in the back from the long heavy trailer it has been towing. Our overheated labor markets say we don't need a push.

If you're looking for a reason why stocks and bonds went out of July like lamb chops, that's my offering. With Friday's upcoming release of the July

employment report

, with its jobs, hours and wage rates data, these markets are unlikely to find tranquility soon.

Jim Griffin is the chief strategist at Aeltus Investment Management in Hartford, Conn. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. Aeltus manages institutional investment accounts and acts as adviser to the Aetna Mutual Funds. While Griffin cannot provide investment advice or recommendations, he invites you to comment on his column at

GriffinJ@aeltus.com.