June 8, 2001

Inflation Fears Dampen Bond Market Rally

The recent rally in the bond market stumbled today as investors took a closer look at inflation and consumer spending. Though many investors bought the party line view that inflation doesn't pose a "significant problem," as more data appears to the contrary, some investors are getting worried.

The economy is not showing signs of recovery. Meanwhile, inflation is beginning to rear its ugly head. Several hundred thousand Americans have been laid off from their jobs just this year, and jobless claims have risen sharply for the past four weeks. It is no wonder that retail sales were weak in May -- and we expect them to fall even more in the coming months. Consumers are finally feeling the pinch of layoffs and high energy prices.

And higher costs have hit businesses as well. Unit labor costs soared 6.3% as worker productivity slowed last month. That may or may not balance out as the economy slows. But one thing is for sure -- businesses have dramatically reduced capital spending, and that will make it harder for them to gear up when the economy is ready to rebound. Also, energy prices are not cooling down one bit, and businesses, especially the already hard-hit, energy-dependent manufacturing sector, will have to raise prices or watch their profits go down the drain.

Not only will investors shy away from bonds as clear signs of inflation appear, but they will also run from the stock market as corporate earnings continue to disappoint and the economy heads toward recession.

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