Bond yields and equity prices will drop further on unemployment and related economic distress

The weaker than anticipated employment report and other developments point to a still further decline in Treasury, corporate and municipal bond yields, as well as a deeper drop in equity prices. This will be an extension of the fall in Treasury 10-year yields to 3.50% from 4.0% in early June and the parallel decrease in equity prices the past three weeks, both developments which emerged despite some "green shoots" signs of moderation in the pace of economic decline.

Though in some respects the recent pace of economic decline may not be quite as steep as previously, the economy is still in a significant recession decline. And even when the economic recovery does eventually emerge, whether in the second half this year or next year, the expansion is destined to be extremely sluggish and fragile. That will keep the markets and policy makers uncertain and deeply worried over an economic relapse. For example, the offical and grossly understated unemployment rate will be unlikely to stop rising until it reaches or exceeds the 1982 recession high of 10.8%. That topping out of the unemployment rate this time is unlikely to occur until 2010 and possibly even 2011. And the Fed will not begin its slow methodical firming exit strategy from easing until well after it is able to confim that the employment situation is sustainably improving. That suggests no rise in the Federal funds rate until 2011. More to the point, there is an increasing realization that there is no realistic near-term inflation risk. That latest realization has begun an unwinding of much of the precautionary speculative inflation fear buying of commodities, commodity-related equities and even the selloff in Treasury bonds that until very recently had dominated market sentiment.

The process of equity market price retreat could be slow to fully develop. But, it is likely to lead to an eventual retreat in the S&P 500 back to at least the 800 area from its 896 level on Thursday. That would merely represent a roughly 50% typical retracement of the rally from 666 to its recent high. But, the decline in equity prices could well go further than that, in a retest of the 666 S&P 500 early March low. Much will depend on the extent of the market's disappointment with the soon to be released second quarter corporate earnings performance, to be followed three months later with the third quarter earnings reports. Both sets of reports are likely to continue weak, and vitually certain to be down sharply from year earlier levels amidst an absence of any meaningful pick-up in demand or business pricing power. Though the percentage declines in earnings are unlikely to be as steep as in the first quarter, the declines will still be significant.

There were ominous elements to the July 2 release of the June employment report that were far more worrisome than the headline details. But, even the headlines understate the seriosness of the problem. For example, the 467,000 June decline in nonfarm payrolls was artificially modified from a 652,000 decline because of a fictitous 185,000 rise in employment attributed to new firms that were not sampled.

Also, consider the June unemployment rate, which was reported to have risen to 9.5% from 9.4% the month before. The official number of those unemployed is now 14.7 million. But, the number of those in extreme employment distress is far larger than that. Including those considered as discouraged workers, who gave up looking for employment because of a lack of jobs, and those working only part-time because they could not find full time work, the U-6 unemployment rate is now 16.5%, up from 16.4% the month before. Including these categories, the number functionally unemployed is now roughly some 25 million, an horrendous total. For an economy dependent on consumer spending, as is the US, that indicates continued sluggishness or stagnation at best, and continued recession at worst. For the global economy, dependant on the US consumer as the engine of recovery, that promises a delayed pick up.

But, there were other especially adverse economic elements in the June employment report. The average work-week declined significantly, to 33.0 hours, the lowest level on record since 1964 when the data series started. And the index of aggregate hours worked was also down, falling a steep 0.8%. Together, these data indicate another appreciable decline in real GDP in the second quarter, perhaps 4.0%, to be reported at the end of July, only moderately less severe than the 5.5% first quarter drop. Also, while hourly earning were unchanged in June, average weekly earnings declined $1.85, more than reversing the $0.99 rise the month before. It is not surprising that the consumer also experienced a renewed weakening in confidence. In concert these data help explain the jump in consumer savings. That pattern of constrained consumer spending, repayment of debt and increased consumer savings is likely to persist for an extended period, keeping the economy weak and stuggling.

The absence of inflation, persistant deflation concerns, an unchanged Fed policy and Fed buying of Treasuries together with declines in equity prices will keep Treasury bond yields low and declining. But, what about corporate and muni yields? The decline in Treasury yields and a narrowing of the still excessively wide quality
yield spreads, the gradual reentry of corporations into the debt market and less onerous earnings prospects will help improve distressed corporate bond prices. Despite the current deep financial distress of California and other states, the Federal assistance to the muni market through 2010 (such as the build America financing) will keep the volume of tax-exempt muni offerings low, ultimately further enhancing their value, especially as the economy eventually begins to improve and the outlook for state finances recovers as well.

Philip Braverman, President
Braverman Economic and Financial Consulting
One Hewitt Square #249
East Northport, New York 11731

Email Address: philipbraverma@Gmail.com

This and prior reports can be accessed by going to Internet Explorer and typing in:
philipbraverman.blogspot.com

The next report is scheduled for early August. Until then be wary of reports suggesting imminent recovery, inflation and Fed firming.