U.S. Review
Rising Rates Heighten Risks
Long-term interest rates jumped this week, as the Treasury received only lukewarm demand for it $101 billion in medium-term securities. The spread between the Treasury’s 10-year note and 3-month bill rose 27 basis points this week and is the widest since last November.
Ordinarily a steeper yield curve would be a persuasive sign of a recovery. This does not appear to be the case today, however. Long-term yields are rising because of the Treasury’s enormous issuance and worries that inflation will accelerate over the long-term. There is little-to-no evidence that investors’ appetite for risk has improved or private-sector credit demand has strengthened. Higher long-term interest rates today are a roadblock to recovery not a milepost.
With the run-up in long-term Treasury yields, mortgage rates for 30-year fixed-rate loans have risen above the psychologically important five percent mark. The rise has cut into demand for refinancings and home purchases. Applications for refinancings have fallen 24 percent over the past month. Commercial loan demand has also weakened and remains soft.
Economic Reports Remain Consistent With a Fall Recovery
While rising interest rates heighten the risk that the economy will stumble on its way to recovery, we believe the recession will end later this year, probably late summer or early fall. This week’s economic reports were generally supportive of that notion. One of the brightest spots was the surprising 15.7 point jump in the Conference Board’s Consumer Confidence Index, which brought the index back to its highest level since September.
While the Consumer Confidence Index surged, there was a huge gap between expectations of future economic conditions and sentiment about current economic performance. Consumers’ assessment of current economic conditions rose just 3.4 points, as many more households remain concerned about the lack of job opportunities and the weakened state of business in general. By contrast consumers’ expectations for future economic conditions jumped 21.3 points following a 20.8 point rise in April. The increase coincides with the 28 percent rebound in the Dow Jones Industrial Average. The surprising strength in the Consumer Confidence Index helped send stocks even higher this week, as hopes for a recovery strengthened.
Most of this week’s other reports remained consistent with a lessening in the rate of the decline in economic activity. Sales of both new and existing homes rose in April, but data for the previous month were revised down and the underlying demand for housing remains weak. The National Association of Realtors estimates that 45 percent of the homes sold in April were either foreclosure sales or some other form of distressed sale. New homes sales rose 1,000 units in April to a 352,000 unit pace. Data for March were revised down, however, so the increase actually resulted in sales being 8,000 units lower than they reported to be one month earlier. Inventories of unsold new homes continue to decline and have fallen to their pre-boom levels. Cancellation rates remain high, however, and the bulk of the oversupply problem is in existing homes rather than builder inventories.
Weekly first-time unemployment claims fell 8,000 to 623,000. The drop marks the 2nd consecutive weekly decline and helped bring the four-week moving average down for the 6th time in the past 7 weeks. Despite the improvement, the actual level of jobless claims remains high and continuing unemployment claims are still rising. The insured unemployment rate rose another 0.1 percentage point, marking the 12th consecutive weekly increase. The current data suggests the unemployment rate will rise to 9.4 percent for the month of May and may reach 10 percent by summer’s end.
Global Review
Tensions on the Korean Peninsula
Geopolitical tensions rose again this week when North Korea conducted an underground nuclear blast on Monday that was followed by missile tests. South Korea and the United States said that they would stop and search North Korean ships in an effort to stop nuclear trafficking, and Pyongyang responded by saying that it no longer considers itself bound by the 1953 armistice that ended the Korean War. Is war imminent on the Korean peninsula?
Investors don’t seem to be worried if the reaction in Korean financial markets is any indication. Yes, the Korean won weakened 1.0 percent versus the dollar (see chart at left) and the Kospi stock index fell 2.0 percent on the day after the tests occurred, but they had largely recouped their losses by the end of the week. Perhaps investors are more focused on South Korean economic news at present.
Recovery Under Way in South Korea?
In that regard, recent data suggest that recovery may already be under way in South Korea. Industrial production (IP) rose for the fourth consecutive month in April, bringing its cumulative rise from its cyclical low in December to 18 percent. Moreover, the marked rise in business confidence in May suggests that industrial production has probably continued to increase this month.
What is behind the rebound in Korean industrial production? Clearly, foreign trade is playing a role. As shown in the middle chart, the country is posting trade surpluses again. Part of the swing from surplus to deficit and back again reflects the rollercoaster ride in oil prices over the past two years that has led to wide swings in the country’s imports. That said, some of the improvement in the trade balance reflects exports, which have risen more than 40 percent in value since January. Exports plunged last autumn as trade finance dried up. Now that credit markets are beginning to function again, exports are rebounding.
There are also some indications that domestic demand is stabilizing. Real retail sales were essentially flat in the first quarter relative to the previous quarter, and the increase in an index of consumer confidence, which rose to a 2-year high in May, bodes favorably for consumer spending going forward. Policymakers have also responded aggressively to the downturn. The sharp contraction in economic activity late last year and the subsequent decline in inflation allowed the Bank of Korea to slash its main policy rate by 325 bps between October and February. In addition, the government enacted a program of infrastructure spending and tax cuts for both businesses and individuals. Expansionary macroeconomic policy has surely helped to stabilize the economy.
Although economic recovery may be taking hold in Korea, we believe that the pace of the upturn will be rather sluggish. First, the global recovery likely will take some time, which should constrain growth in Korean exports going forward. Second, Korean households have increased their leverage over the past few years, and we expect a period of slow growth in consumer spending as households reduce leverage. That said, Korea appears to be climbing out of its brief, albeit sharp, recession.
