A gloomier economic outlook has emerged in the past few weeks. There are a variety of fundamental factors that the bears are citing for their pessimistic views. One of these concerns is the rising long term interest rates that are being associated with rising budget deficits and the increased sovereign risk concerns of holding U.S. Treasury debt. According to the financial futures markets, there currently is a possibility that the Federal Open Market Committee could increase their fed funds target by 25 basis points to 50 basis points before the end of the year. Our own analysis suggests that a rate increase from the Federal Reserve this year is very unlikely. However, there could be one later next year, especially if we are correct in our thinking that we are on the road to economic recovery. The vast majority of the primary government securities dealers also believe that there will not be an interest rate increase from the Federal Open Market Committee this year and that the financial futures markets are incorrectly pricing in such a high probability of a rate increase. In some quarters there is a growing feeling that higher long term interest rates, including higher mortgage rates will forestall any recover in the housing market.

The World Bank lowered its forecast for U.S. economic growth in 2009 to a 3% drop from the previously projected 2.4% contraction that they had made in March. In addition, they said the global recession will be deeper than it had predicted previously and warned that capital is moving away from the developed countries. The World Bank said their estimates show the global economy will contract by 2.9% this year, which compares to their earlier estimate of a 1.7% contraction. They also predicted that growth in 2010 would be only 2%, which is down from their prior prediction of 2.3%. According to their estimates, global trade could decline by 9.7%, which compares to their month ago prediction of a 6.1% drop.

The bears on the economy cite the rising unemployment rate which is currently at 9.4% and, according to some analysts, is projected to rise to over 10% later this year or next year.  Weekly jobless claims remain stubbornly high at the 627,000 level, while continuing jobless claims were slightly larger than projected at 6.74 million. Comments from the Federal Reserve in their “Beige Book” on the economy were only slightly more optimistic when they said the U.S. economic downturn may be slowing in almost half of its regions, although a “weak” labor market persists. Specifically the Fed said “labor market conditions continued to be weak across the country, with wages generally remaining flat or falling.” Although current unemployment numbers are historically at very high levels, even the bears on the economy concede that employment data is a lagging indicator rather than a leading one.  

The Federal Open Market Committee’s statement at the conclusion of their June 23-24 meeting signaled that the nation’s central bank will keep the low interest rate structure for some time. Currently they appear to be in no hurry to increase interest rates any time soon, in spite of the hawkish implications of the rising interest rate projections inferred from the fed funds futures contract. The Federal Reserve said they remain worried about the economy, while playing down deflation concerns.

U.S. Dollar

Our analysis continues to show that the worst of the global economic downturn is behind us and that we can expect the majority of the economic reports for the balance of this year and well into 2010 to be stronger that the analysts’ estimates.   Any improvement in the U.S. economy should be U.S. dollar supportive, since it will attract capital flows. Also, a recently established trend toward greenback favorable interest rate differentials should continue through this year and well into next year.  Expect higher prices for the U.S. dollar.

Interest Rate Markets

If we are correct in our thinking that the economy is recovering, we can expect loan demand to increase. It is likely that the Federal Reserve will start to reverse some of the accommodation next year when there is clear evidence that the economy is on the mend. Under these anticipated better economic conditions, we can expect lower prices for the entire interest rate market complex.

Stock Indexes

Many traders and analysts are worried that higher short term interest rates and firming commodity prices are bearish for stock index futures. We take an opposite view. At this stage of the economic cycle, a higher interest rate structure is a reflection of anticipated greater loan demand in the near future and firming commodity prices suggest manufacturing activity is about to increase. All of this is bullish for stock index futures prices. Most likely the lows for the move have been made and a new multiyear bull market is emerging.   

If you would like more information about this article, please call Alan Bush at 1.800.243.2649 or email him at alan.bush@archerfinancials.com .

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