GDP Data Could Reset Treasury Yields

The economy is set to grow strongly, and previous inflation was revised up. Expect more rate hikes.
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Today's report on the second quarter's gross domestic product clearly indicates that the U.S. economy is poised for additional strong growth in the quarters immediately ahead. As a result, the bond market is continuing to raise its year-end target for the fed funds rate, with odds now placed at 25% for a 4.25% year-end rate compared with zero percent odds two weeks ago. This is in sharp contrast to the view a month ago when a 3.75% year-end funds rate was expected.

As I mentioned in my

last column, should the 4.25% fed funds view become solidified, the yield on the 10-year T-note may set a new trading range, moving up to 4.25% to 4.75% from the 4.00% to 4.50% range that has prevailed for two years. The range could shift because it is rare for Treasuries to trade below the fed funds rate.

Major Features of GDP

GDP rose 3.4% during the second quarter, but it would have grown a lot faster if not for a huge decline in business inventories. Inventories subtracted 2.4 percentage points from GDP, meaning that GDP would have been reported up at a 5.8% pace instead of 3.4%. With inventories having fallen so substantially during the quarter, the economy is poised to grow more strongly in the months ahead.

Inventories are so lean that any increase in demand will have to be met by increases in production, which will boost the economy. The inventory draw in the automobile sector was particularly large, which helps to explain why

General Motors

(GM) - Get Report

has decided to end its employee discount sales program, owing to the leanness of its inventories.

The trade drag was nil during the quarter. In fact, trade actually added 1.6 percentage points to the GDP figure, an unusual event. The boost relates partly to the inventory correction that occurred during the second quarter, as companies reduced their imports of goods from abroad, thus boosting GDP. This phenomenon will likely end when inventories are rebuilt, as companies will hence begin to import again.

Strong Capital Spending, Solid Outlook

Spending on equipment and software was stronger than expected, rising at an 11% pace instead of the midsingle digit gain that was expected. The rise continues the strong pace of gains seen over the past two years, where gains have averaged 13.3%. The gain is not surprising in light of the unusual amount of cash that companies are holding relative to capital spending.

Companies thus have plentiful internal funding to finance capital spending projects. This, combined with the fact that capital investments are continuing to yield high rates of return via increased productivity and hence corporate profits, augurs well for future gains in capital spending.

Spending on structures, which includes commercial real estate and oil and gas rigs, for example, rose at a 3.1% pace. Spending in this sphere was extremely weak in 2001 and 2002, falling 25% cumulatively and subtracting 0.4 percentage points from the GDP tally for each of those years before beginning a very modest rebound in 2003.

Since then, spending on structures has increased $31 billion to a $253 billion annualized pace, still a far cry from the peak of $321 billion set in the fourth quarter of 2000. From these data it is clear that despite all of the recent talk of a bubble in the residential real estate market, the commercial real estate market is a much different story.

Weak Service Spending

If there's a disappointment in today's data it's in the weak pace of spending on services, which rose at a 2.3% pace during the quarter, the weakest pace since the second quarter of last year. For the economy's sake, the weakness is hopefully an anomaly given the importance of the service sector to the labor market: Of the 134 million people employed in the U.S., 111 million people work in the service sector. The previous four quarters were the best four quarters in four years, so it is not clear yet that the trend has worsened, especially in light of recent strength in the Institute for Supply Management's nonmanufacturing index.

Revisions Put GDP Lower, Inflation Higher

In a benchmark revision, the average annualized gain in GDP for the years 2001-04 was revised downward 2.8% instead of 3.1%. A major reason for the revision was an upward revision to inflation, with the GDP deflator revised upward to show an average annual gain of 2.2% instead of 2.0%. The revision to the inflation data reinforces the recent increase in expectations for additional interest rate hikes from the

Federal Reserve

.

All of this raises risks to the bond market and to the interest rate-sensitive sectors of the equity market. The recent weakening of homebuilders' shares is consistent with this; the Philadelphia Stock Exchange Housing Sector Index was recently down 1.5%, weighed down by components such as

Pulte Home

(PHM) - Get Report

,

Toll Brothers

(TOL) - Get Report

and

Champion Enterprises

(CHB)

.

Potentially Pivotal Week

Next week's economic news will be pivotal for the financial markets. If the data result in further increases in expectations for a fed funds rate of 4.25% or higher, then the trading range for the U.S. 10-year might be reset. Further strengthening of the ISM index accompanied by an above-trend payroll gain (higher than 180,000) would raise the odds that the Fed will raise interest rates in all of the four remaining Federal Open Market Committee meetings for 2005. In response, the yield on the 10-year will move toward the upper end of its two-year trading range, likely impacting equities in the process. Credit spreads are likely to widen in this scenario.

Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. His first book,

The Strategic Bond Investor

, will be published in July by McGraw-Hill. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. He appreciates your feedback;

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to send him an email.