As stocks failed to extend Wednesday's advance, Treasuries had another turn at the rally table on day two of Ben Bernanke's semiannual testimony before Congress. For better or worse for the economy, bond investors appear confident inflation won't run rampant. Judging by the recent decline in Treasury yields (which move in opposition to their price), bondholders believe that growth will slow dramatically to bring down inflation, or that incoming data will not allow the Federal Reserve to stop raising rates and inflation will come down with further tightening. Either way, the entire Treasury yield curve rallied Thursday, with all maturities trading further below the 5.25% fed funds rate, a historically rare occurrence. The 10-year Treasury bond rallied 6/32 to yield 5.03%, while the two-year gained 2/32 to yield 5.06%; the five-year added 5/32 to yield 4.98%. Stock investors don't work well with the notion of an economic slowdown, and the market once again failed to follow through on Wednesday's surge. A heavy dose of mediocre earnings and news of an indictment in the options-backdating scandal of Brocade ( BRCD) former CEO Gregory Reyes weighed on the markets. Among the highlights (or lowlights), Ford ( F) posted a poor quarter, while Intel ( INTC) and Qualcomm ( QCOM) released disappointing earnings guidance. (After the close, however, Microsoft ( MSFT) and Google ( GOOG) each reported stronger-than-expected results and were recently rallying in after-hours trading.) The Nasdaq bore the brunt of the selling Thursday, declining 2% to 2039.42, despite a big postearnings gain by Apple ( AAPL). The Dow Jones Industrial Average ended near its lows of the day, down 0.8% to 10928.10, and the S&P 500 fell 0.85% to 1249.13. The Dow Jones Transportation Average, whose components are acutely economically sensitive, fell 4.36%.
Gentle BenRightly or not, much of Wednesday's advance was credited to this comment in Bernanke's prepared testimony:
"The growth in economic activity should moderate to a pace close to that of the growth of potential both this year and next. Should that moderation occur as anticipated, it should help to limit inflation pressures over time."
But inflation is not driven by energy and commodity prices alone. Bernanke himself acknowledged the tight labor market, which he says is likely to drive up wages. However, he believes productivity gains mitigate wage-based inflation pressures. Furthermore, most economists dispute the idea that slowing growth reduces inflation per se, insisting that inflation is a monetary phenomenon, not a growth phenomenon. "It is excess liquidity -- not strong growth -- that drives inflation," says Michael Darda, chief economist at MKM Partners, who is among those believing the lag effects of historically low interest rates in the early part of the decade have led to inflation. And it seems that gentle, academic Bernanke isn't quite sure, either, saying, "growth doesn't cause inflation" during the Q&A portion of his House testimony Thursday. Thus far the economy disputes the "growth causes inflation" theory as well. Growth is slowing and inflation is increasing. Thursday's Philadelphia Fed survey is the most recent illustration of the Fed's conundrum. The survey showed that manufacturing in that district is declining, that the headline index fell to 6 in July, down from 13.1 in June and below expectations for a reading of 12. The new-orders index fell to 10.1 from 17.7 in June, and the index of shipments fell to 10.2 from 17.7. But strength appeared in the employment index, which rose to 12.8 in July from 6.8, and ( ta-dah) the prices paid index, which rose to 50.3 in July from 48.7 in June. "Reversing inflation requires below-trend growth in the economy, and the bigger the inflation problem, the more pain is required," says Ethan Harris, chief economist at Lehman Brothers, who does not believe the economy is headed for a recession. The economy is underpinned by strength in business spending, U.S. exports and commercial real estate development, among other factors, he says. Therefore, Harris believes the Fed is too complacent about inflation.
The minutes from the June 29 FOMC meeting reflect the Fed's confusion about the growth and inflation scales. The members couldn't decide on whether a 5.25% fed funds rate was "modestly restrictive" or "somewhat accommodative." Their confusion could be due to Bernanke's moving targets for inflation and price stability. In early June, the market heard several Fed speakers rant about the 1% to 2% inflation "comfort zone." But Bernanke and the Fed seem suddenly comfortable with inflation at over 2% through 2007. "Inflation is projected to be 2.25% to 2.5% this year, and then to edge lower, to 2% to 2.25%, next year," writes Bernanke in his testimony. "That is a huge move," says Gary Bigg, associate economist at Bank of America. "We were somewhat surprised by this degree of Fed patience." Meanwhile, the higher-than-expected 0.3% rise in core consumer price inflation in June was widely unnoticed Wednesday. The fourth consecutive higher-than-expected CPI reading put its year-over-year growth at 2.64%. The Bernanke rally was short-lived in stocks, but perhaps not for bonds. Maybe investors took a moment last night to look back at February's semiannual report to Congress to find the Fed chief's forecast wasn't exactly spot-on. "For a guy with great forecasts, he didn't say in February, 'Don't be blindsided by stronger inflation numbers,' " quips James Bianco, president of Bianco Research.