FLUMMOXED AT MORGAN. Want more proof that the forces of monetary austerity are on the run, flummoxed by the absolute refusal of the real world to respond in the fashion prescribed by their archaic preconceived notions? This week, economists at Morgan Stanley Dean Witter, paragons of Wall Street’s conventional economic wisdom, told clients, “We’ve been too bearish on U.S. Treasury yields…. we overestimated near-term inflation risks….recent upward revisions to past economic growth, and a surprisingly vigorous spring quarter, have only reinforced perceptions that the economy can grow at 4% or more without a pickup in inflation…. We expected that rising headline inflation would further hike inflation expectations….So far, however, higher energy costs appear to be slowing the economy more than they are hiking inflation expectations.” But don’t get the idea that their sweeping failure to explain the economic forces actually at work might spur a deeper re-think of fundamental precepts. Though chastened, the Morgan economists were quick to add: “…inflation risks remain, and the Fed’s job is incomplete….” The job will not be finished, they insist, until the Fed moves to a 7% funds rate, probably by the first quarter of next year.

ANTICIPATING RATE CUTS. That assertion, though, also likely faces future retraction, as the credit markets bet that the Fed’s next move is more likely to be an ease than a tightening. Certainly, with the 2-year note some 35 basis points below the 6.5% funds rate, and the 30-year bond inverted by nearly 50 basis points below that, the overnight rate must be seen as grossly out of step with a climate of virtually non-existent current and expected future inflation.  Beyond that, though, the yield curve inversion indicates that the market is positioned for additional gains at the long end of the yield curve in anticipation of the Fed moving short rates significantly lower. Bond buyers will accept less yield on higher-risk, long-maturity issues  expecting additional capital gains when falling short-term rates allow long yields to push lower. Market expectations, of course, are not infallible, but the accompanying chart helps place the current yield curve inversion in some historical context relative to the funds rate. In the past 15 years, the only other instance of a sustained inversion as steep as the current one came at the end of the Fed’s 1988-89 tightening exercise, which soon gave way to an aggressive easing campaign. It’s also interesting, though, that even significant curve-flattenings that stopped short of outright inversion anticipated subsequent rate cuts, including those in spring 1995 and fall 1998.

Yield Curve versus Funds Rate

EQUITY BREAKOUT. Notwithstanding Thursday’s point-plus long-bond rally on further optimism that the tightening cycle is in all likelihood over, available returns in equities are likely to continue outpacing those in fixed income in the near-term. Pending more conclusive indications supporting rate-cut expectations, bonds probably have come close to reaching their upside limit, and look to maintain a range around 5.65-5.75%. Stocks, though, face no such limitations, and can continue rallying on the favorable factors that have yet to be fully discounted in the credit markets. The shift from Fed-induced fears of rising inflation to growing realization that there is absolutely no threat to dollar purchasing power should be particularly beneficial to the higher-risk, New Economy equities concentrated in NASDAQ. The market capitalizations of these stocks are based on longer-range, and thus more uncertain, growth expectations. Not only does the prospect of lower future interest rates discount to a higher net present value for these issues relative to those based on nearer-term earnings and dividend calculations. Perhaps even more importantly, the diminution of expected inflation means a lower effective capital gains tax rate and thus a higher expected real, after-tax rate of return on riskier stocks whose investment appeal is so closely geared to opportunities for long-term capital gains.