Spending What Isn't There

Tuesday's data portend a day of consumer reckoning.
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Once again, beneath the headlines, economic data released Tuesday point to inflation and other risks in the economy.

Personal spending rose 0.8% in June. This would be reason to cheer if spending hadn't risen at a faster pace than personal income, which rose 0.5%. That takes the personal savings rate to 0%, the lowest level since October 2001, when a spending binge left it at negative 0.2%.

We could get there again given that strong auto sales, boosted by slashed prices, continued through July. Already Tuesday,

Ford

(F) - Get Report

said its overall July sales rose 29% from a year ago, while

DaimlerChrysler's

(DCX)

U.S. car and light truck tally was up 32%.

Why does high spending matter? For one thing, it hints at no improvement in the current account and trade deficits, which is bearish for the dollar and therefore for inflation down the line.

It also raises the risk that if the consumer slows down, the drop in spending may be even more painful, says Drew Matus, economist at Lehman Brothers.

"It could be that people are spending ahead of expectations that income growth will pick up," he says.

So far, that's not happening. Wages and salaries rose only 0.2% in June. Of course, the income and spending data are not taking into account home-equity wealth. The boost to consumer confidence from ever-rising home prices can hardly be overstated at this point (both new- and existing-home sales reached record highs in June).

The risks to consumption and the economy can't be overstated going forward. "If the housing market slows, it will have a much bigger impact on the U.S. consumer

than other factors," says Lehman's Matus.

The rise in the yield of the 10-year Treasury bond, used to benchmark mortgage rates, should eventually provide, at the very least, a cooling in the red-hot housing market. Bonds have been falling and yields rising since early July, with the market now pricing in that the

Fed

will lift short-term rates to at least 4% by year-end.

Inflation indications in Tuesday's personal income/spending data also point that way. The core personal consumption expenditures price index -- the Fed's favorite measure of inflation -- was flat in June. But more importantly, the core PCE is up 1.9% on a year-over-year basis, due to revisions of previous income data going back to 2002. That's near the top of the 1%-2% range where the Fed likes it to be.

"The bottom line for the Fed is that the revised income and inflation figures show the economy has more resiliency and a bit more inflation than previously thought," says Mark Vitner, senior economist at Wachovia, in a research note.

The data leave little doubt that more rate hikes are on the way, underpinning rising market expectations that the Fed may continue tightening into next year.

The bond market also reached that conclusion, with the 10-year dipping 5/32 while its yield rose to 4.33%.

Stocks, meanwhile, continued to rise as oil prices fells, and with the bullish economic data fueling buying interest. The

Dow Jones Industrial Average

(DJI)

was recently up 64 points, or 0.6%, at 10,687, and the

S&P 500

(SPX)

was up 7 points, or 0.6%, to 1243. The

Nasdaq Composite

(NASDAQ)

was 19 points, or 0.8% higher, to 2214.

The stocks of homebuilders, which have been underperforming the S&P since last week, dropped again as bond yields rose. The Philadelphia housing index was recently down 0.3%.

With weakness in this key interest rate-sensitive sector, the consumer may not have that many more sunny days ahead.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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