Interest Rate Profile / Bond Market

By my nearly 100 year regression model of short rates vs.
the consumer price index (CPI), Fed Funds should be 5.75%
rather than the current 5.25%. The Fed is pricing off key
GDP account deflators which yr/yr have moved up to 3.0%
and suggest an FFR% of 5.25%. Since I believe the CPI,
despite its many flaws, is a more realistic inflation
estimate, I conclude short rates are still on the low side,
and provide a negligible incentive to save.

Based on data at hand, short rates should still be trending
higher. However, and as mentioned in the 6/29 note, such
may not be the case by the mid-August FOMC meeting, as the
economy is slowing. In fact, my bevy of cycle pressure gauges
are nearing breakdowns, signaling milder growth ahead.

The national yr/yr CPI through May is 4.1%, about the same as
for the New York metro area. With 4% inflation, there is little
incentive for me to buy bonds, and I have stayed away from this
market for over a year. With 4% inflation, I would like to see
a US Treasury at 7% instead of the current 5.27%.

The yield curve is essentially flat in the Treasury market. A
flat yield curve normally suggests a significant slowing of economic
growth is at hand. This is because a flat to inverted yield curve
signals a liquidity squeeze is developing and that credit
availability is coming into question. Such is not the case now.
The US economy is slowing, but credit remains ample. Thus the
flat yield curve represents not so much a dark view of economic
prospects as it does the opinion of the market that a moderate
economic slowdown will reduce inflation pressure and ultimately
allow the Fed to ease again. This is born out by the continuing
tight yield spread between top quality corporates and "A" rated
intermediate bonds. The forecast implicit in current bond yields
goes beyond what I would care to sign on to at present.

The long Treasury has been rangebound between about 4.25% and 5.50%
since 2003. The market has been very sensitive to the momentum of
production growth and the trend of industrial commodity prices over
this period. Accelerating production growth and rising industrial
prices have lead to rising yields, and decelerating production
growth and quiet or declining industrial prices have provided
the bond market rallies. We may be moving into a period of
lower production growth and quieter industrial pricing that could
last for several months. So, there could be a rally in bonds. I
doubt it will carry far if the Fed keeps short rates on a plateau
which I suspect is the course it will follow. A more powerful
bond price move could occur if the economic momentum decreases too
sharply, but my indicators do not suggest that drastic a slowdown
at this point.