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Friends and Colleagues

What’s behind the recent run-up in Treasury yields? This week Michael Swanson, PhD of Wells Fargo Economics shares his insights on how the market perception of inflation has impacted rising treasury yields.

What Just Happened?

A 55 basis point increase in the 10-year Treasury yield over the last 30 days caught the financial markets flatfooted.
The increase has raised concerns that higher financing costs will depress the housing market even further.
The market’s run-up in yield reflects a series of stronger than expected economic releases.
Dr. Swanson projects that 2nd quarter GDP growth will range from 3.1% to 3.6%.
He tells us that both the Treasury and Fed Funds markets project increasing resource utilization and higher inflation.
His view is that in response, the markets have bid up bond yields to protect themselves from that risk of inflation.

Is Inflation Really Rising?

Ironically, the BLS (Bureau of Labor Statistics) has continued to issue lower estimates of core inflation during the same period.
The core inflation rate was 2.72% in February, but it dropped to 2.26% in May!
Currently, there is a clear divergence between overall inflation and core inflation.

Overall Inflation:

Food and fuel make up 22.6% of the urban consumer’s spending in the 2006 BLS weighting.
This sector of overall inflation is up due to higher crude oil and natural gas prices.
These have in turn led to higher grain-related food prices due to the increased demand for ethanol.

Core Inflation:

Within the core index, the BLS has noted a sharp decrease in shelter inflation.
Rent of shelter, which even includes houses people own outright without debt, makes up 32.4% of the total inflation index.
Shelter inflation hit a rate of 4.33% YOY in January, roughly equal to its peak in 2001.
Since January, shelter inflation has fallen to 3.75%, and it appears to be on track for further declines as the housing/rental market looks to absorb excess housing stock via conversion to rental units.
However, many apartment rental markets are actually seeing rents rise faster as renters who became first time home owners and failed to make the transition, move back to apartments.
This reversal of the dynamic has a number of markets seeing falling apartment vacancies, which increases rent price pressure.

According to Dr. Swanson, the real take-away is that the BLS inflation measurement around shelter is entirely too simplistic and over-weighted for the markets to trust as a good measure of inflation. He contends that the markets know this, which is why falling core inflation hasn’t translated into falling

bond yields.

Wells Fargo projects that Treasuries will settle down shortly and they will stabilize at 4.95% through the end of 2007 and into 2008.

But Dr. Swanson….what about changing global markets?

Were US Treasuries impacted by New Zealand’s recent increase in their interest rate?

What about the suddenly volatile China stock market? How has that impacted interest rates?

So many questions….and who really knows?

Thus our story continues as we and our clients continue to place our bets on the marketplace.

As the markets grow more interesting, knowledge continues to be key…..so as always, stay tuned……..

THOUGHT FOR THE WEEK

Life – Drama or Comedy?

Last weekend I had the great pleasure of gathering with some lifelong friends from around the country as we all celebrated turning 50 this year.

We shared memories…of our successes….our challenges…our pain….

We talked of mistakes that we made….

We recalled how we agonized over which paths to take along the way….

Most of all, we shared laughter…..lots and lots of laughter.

Why does life seems so funny in retrospect?

Along the way it often feels so serious…like the world is riding on our shoulders.

But looking back, the drama of our lives becomes the comedy of our memories.

Maybe it’s because we know the ending to each of the stories already….or maybe it just wasn’t as serious along the way as we thought.

We all have heavy matters in our lives to attend to.

Perhaps if we see more humor along the way, we will enjoy the ride that much more.

In the week ahead, may each of us find some humor…even in the midst of our drama.

May the laughter that we share, provide strength for us and for those around us.

Have a good week.

David

David Rosenthal, MAI
President & CEO

Curtis-Rosenthal, Inc.
5959 W. Century Blvd., Suite 1010
Los Angeles, CA 90045

Offices in Los Angeles, San Francisco and Newport Beach

Proudly serving the California Marketplace since 1983

310-215-0482 ext. 225
drosenthal@curtisrosenthal.com
www.curtisrosenthal.com

BACK

Friends and Colleagues

This week Michael Swanson, Ph. D. with Wells Fargo Economics shares some thoughts on Inflation, Oil Prices, Demand for Corn and Interest Rates.

Here are some fun facts from Dr. Swanson’s analysis.

Core Inflation vs. Overall Inflation

Recently inflation statistics showed a slowing of the core inflation rate (excluding food and energy) from 2.72% in February to 2.48% in March.
In contrast, overall inflation (including food and energy) increased from 2.41% in February to 2.78% in March.
The Federal Reserve has stated that it prefers the core measure to the overall one because it eliminates the short-term supply shocks that increase price volatility.
It is often true that food and energy prices often reverse themselves following some unexpected supply shock, but it is not always true.
This makes the Federal Reserve’s practice reasonable, but it also increases the risk that the Federal Reserve will fail to respond to energy and food inflation when it is something other than a transitory supply shock.

Oil Prices

Dr. Swanson has recently increased his price outlook for crude oil prices over the next 2 to 4 years.
His basic rationale is that OPEC has found a cohesiveness that they have lacked for the better part of two decades.
The current price of oil will support the enforcement of cartel-based supply restrictions to maintain higher prices.
The biggest risk to the Federal Reserve is that the 1980 energy inflation debacle will repeat itself.
OPEC restricted output by 45% from 1979 to 1985.
During the same period, Non-OPEC production increased by 18%, and global usage declined by 8%.
Eventually, the OPEC cartel lost its effectiveness as members started pumping increased amounts to make up for declining revenues.
This breakdown of the cartel led to an 18-year period of relatively low oil prices.

Demand for Corn?!

The Federal Reserve must also be monitoring the impact of crude oil prices on food inflation via the ethanol linkage, which has grown rapidly in the last four years.
In April 2002, US ethanol production was utilizing 770 million bushels of corn per year.
Currently, ethanol is utilizing 2.2 billion bushels of corn per year.
This tripling of usage has impacted the dairy and protein markets, and it doesn’t appear that it will be reversed in the short-term.
The most recent run-up in food prices has not yet been captured in CPI measurement.
Spot prices for beef are up 16% from a year ago, and milk futures are projecting a 37% increase in 2007.
Unlike short-lived spikes in fruit and vegetable increases due to weather problems, these increases will persist as long as the cost of feed stays high.
The Federal Reserve will find it difficult to defend its position that food inflation should be ignored in its monetary policy decisions.

And What of Interest Rates?

Nevertheless, Fed Funds interest rate futures have started to slide back down from a December peak of 5.06% to the recent 4.96% on April 13.
This implies that traders have one rate cut priced in before the end of the year, and they are debating whether the Fed will make it two cuts.
Wells Fargo’s forecast, which is contrary to the market’s expectation, still sees the economy muddling through with 2% growth and above target inflation growth.
Dr. Swanson ponders whether the Federal Reserve will begin to consider the importance of including energy and food prices in inflation statistics in the coming months/years.

Oil, corn and interest rates?!

The financial landscape continues to become more intricate and more challenging to project.

As always, the best remedy is to stay informed…..so stay tuned…….

THOUGHT FOR THE WEEK

Children See, Children Do….

This week, I was truly moved by the attached video clip, and I felt it was important enough to share in this space.

Our children are sponges….they absorb and learn from what we say and what we do.

In the weeks ahead, may each of us be mindful that our words and actions may be the most powerful training that our children receive.

May those of us who are blessed with children choose to honor the awesome power and responsibility of being a parent.