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Bond Outlook May 9th

The housing bubble deflation pushing toward a Fed rate decrease, and the tight labour conditions still threatening inflation and a Fed increase. Which will win the “race”?

Bond Outlook [by bridport & cie, May 9th 2007]

A few months back, reflecting on the Fed’s explicit fears about inflation, our view was that the next move in the Fed rate would be up. Then the impact of the sub-prime problem on GDP growth led us and many others to suppose that the US economy would slow so much that the only direction the Fed rate could move was down. Yet the Fed continues to stress the risk of inflation more than the risk of a slowdown. This is mainly because of the remarkable resilience of employment and earnings (household and corporate) in the USA, plus, of course, the continuation of household spending quite beyond earnings. It is precisely because unemployment is so low that the Fed fears inflation.

 

One view (e.g. expressed in the FT) is that there is a sort of race going on between labour getting ever tighter (suggesting a higher Fed rate) and the housing market’s knock-on effects slowing the economy too much (suggesting a lower Fed rate). We see the “race” in somewhat different terms: will the strong economies of other parts the world and the weaker USD compensate for the decline in US household spending when reality finally catches up with household earnings? Our view, based on our conviction that rebalancing is under way, remains that the USA must go through a period of belt-tightening, but that the impact on the rest of the world will be largely mitigated by non-US domestic demand growing .

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