The US economy has been helped by continued strength in the export sector. While most economists called for slowing, if not negative, GDP growth in the first quarter, the preliminary data showed a 0.6% increase. The final data for Q1 came in at a 0.9% increase. While the slowdown in housing and its ancillary industries has been a drag on growth, the weaker dollar has provided a backstop for the struggling economy. Economists are now starting to shift their recession bias towards more subtle slow growth in Q2; however the consensus remains for strong growth in Q3 and Q4.

Whether the economy has weathered a recession or not is essentially moot at this point; what is more important is a sustainable recovery into the later part of 2008. Without a doubt, the road ahead is not clear of all obstacles, including building inflationary pressures from rising energy prices in both crude oil and gasoline. While core (ex-food and energy) consumer price inflation is running at a year-on-year rate of approximately 2.4%, the overall rate, the one that we consumers deal with every day, is closing in on 4.0%. The rise in inflation is now being felt across many industries including trucking, airlines and chemical aggregates. As an example, Dow Chemical, which makes everything from paints to pharmaceuticals, announced an increase in prices of 20% across the board. Price increases such as this now have the Federal Reserve rethinking overall monetary policy.

The Federal Reserve lowered interest rates from 2.25% to 2.0% on April 30. This was the seventh interest rate cut they have made since September 2007. In many analysts’ view, it may be the last. The Fed’s willingness to provide significant amounts of liquidity through the reduction in the Fed fund rate and through other commercial auction processes, has seemingly provided the targeted stability the Fed governors sought. However, talk by Fed officials post the April rate cut has been much more cautious, with repeated discussion of the risk of inflation now in the market. In their April 30th statement, the Fed said,

“Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months.”

It appears now that fixed income investors believe the Fed’s work is done, and further rate cuts are less likely. Indeed, the probability for an unchanged rate decision at the Fed’s June 30th meeting now ranks near 90%, and just 8% for a 25 basis point cut.

Along with changes in Fed policy, has come a change in Treasury market activity. For many months, the 10-yr Treasury bond has maintained a steady yield near the 3.5% level. The thinking was that a continued “flight to quality” trade would remain in place during market turmoil and allow the Fed to continue to cut rates. As of the end of May, the 3.5% level was essentially abandoned overnight in favor of a 4%+ range. This came on the heels of an upwardly revised GDP and signals that the Fed had completed this cycle of rate cuts. The good news that can be read from such a move is that the fixed income community believes, right or wrong, that the credit crisis may be behind us. However, the early June downgrade of several large Street broker dealers, including Lehman Brothers, Merrill Lynch and Morgan Stanley, suggest there may be some further write downs ahead. In either case, the Treasury market has seen a significant shift which is also being reflected in the yield curve. The 2-yr / 10-yr Treasury spread, which had been as wide as 200 bps in mid-March, now sits at 135 bps at the end of May. Compared to the 25 bps spread in August 2007, the market has come a long way.


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