There is still an economic chill in the air

By David Helscher
Special to the Herald

June 22, 2009 09:41 am

— A recent morning drive took me by Riverview Swimming Pool. It reminded me of swim lessons many years ago.
School had adjourned and beginning swimmers were assigned the first class, before the air had warmed and early enough in the season that the water in the pool had not yet warmed. We tadpoles would pace the side of the pool, attempting to determine if the water temperature had improved or who would be the first to take the plunge.
Investors have already been testing the waters as the major stock averages have moved up sharply from their March lows. The spread between the three-month LIBOR and three-month treasury has significantly narrowed, an indication of risk perception between lending parties. The markets have been receptive to new debt and equity offerings from financials as $75 billion has been raised by banks to replenish capital required by the Federal Reserve.
Ten major banks have been allowed to repay the TARP funds advanced last fall. Leading economic indicators have posted positive numbers in recent months, forecasting an end to the recession. The media has been reporting the appearance of the initial “green shoots” of stabilization.
There remains a chill in the air, reflected in unemployment rates and inflation concerns. Unemployment continues to move higher, standing at 9.4 percent. The consensus is for unemployment to continue to move higher through 2009. Inventory reductions have yet to begin to be replaced, holding down new hires. April’s inventory to sales ratio was only slightly higher than January's record low.
However, half of the jump of the past two months unemployment rate increase can be attributed to a surging labor force, which has expanded the past two months the most in five years.
Another reason for concern to investors is the recent rise in Treasury yields. As prices on bonds decline, yields increase, which can be a sign of a perception of an increase in inflation, reducing the purchasing power of bond payments. The recent run up in yields had pushed the average 30-year mortgage rate to nearly 5.8 percent. This threatens the recovery in housing. The Mortgage Bankers Association recently reported new mortgage applications fell by 15.8 percent, re-finance applications declined 23 percent and purchase applications fell 3.5 percent. Higher mortgage rates can eliminate potential buyers.
The Federal Reserve may need to continue to purchase securities, moving bond prices higher and yields lower, as part of their program of quantitative easing.
In addition, investors, both domestic and foreign, are concerned about the size of the U.S. debt. Finance ministers from several major holders of dollars have expressed concerns over continuing to hold dollars or substitute another currency as the global reserve currency. This is due to concern about the value of the dollar and declines relative to other currencies. About 42 percent of the current Treasury debt will mature in the next year, which is before the new debt it will need to float. The average maturity of all Treasury bonds and notes outstanding is 4.7 years. This compares to an average of 14 years for Britain and around 10 years for many European countries. With this amount of roll-over approaching and the new debt to be issued, investors are concerned that supply will exceed demand, causing nominal rates to rise on new and rolled debt, compounding U.S. debt problems. Crude oil is priced in dollars and declines in the value of the dollar adds upward momentum to crude oil prices and gas prices at the pump. A large jump in gas prices in the U.S. could hurt consumer spending and choke off the “green shoots” of recovery.
The possibility of inflation is in the perception of how the U.S. will handle its debt. Recent indicators show inflation to be in check. The annualized increase in the core consumer prices index was reported at 1.8 percent in June and core wholesale prices declined 5 percent from a year ago. The high current employment rate would indicate labor costs will not add to inflationary pressures any time in the near future. The Federal Reserve can increase key interest rates to attempt to stave off inflation, but have indicated that rates will remain low for a significant time. Fed Funds Futures traders are currently indicating that the Fed will not raise rates until early 2010, at the earliest.
The hour might have been early, the air temperature might have been cool, but I do not remember any ice on that pool when I learned to swim.
It wasn’t bath water, but as the instructor said at the time, you will warm up once you get in. My fellow tadpoles and I did take the plunge, but we were warned to avoid the deep end until we had learned to swim.

David Helscher is a senior vice president and trust officer with Clinton National Bank.