While many analysts are predicting that interest rates will rise to 10 percent by the end of 1987 and others are talking 10 percent to 12 percent in 1988, one forecaster, Sam Nakagama, believes that the interest rate on the 30-year Treasury bond will fall to 8.80 percent within the next three months. However, Nakagama admits that big problems exist and, if they are not corrected, an economic and financial crisis could occur in 1988 or 1989.
As Nakagama sees it, "The financial markets are reacting to events that are not really happening." Further, the government is not responding to the lack of confidence being manifested by the bond market. The crisis would occur if "rates rise so much, contrary to what's happening with the economic fundamentals" that it becomes impossible to anticipate what will happen next year.
There are several events that lead Nakagama to forecast that interest rates will fall by year end. For one, he says that the biggest rise in inflation happened in the first quarter of 1987, and that inflation has been declining ever since. Inflation for the first half of 1987 was 5.4 percent and Nakagama looks for an inflation figure of 3.0 percent to 3.7 percent during the last half of the year.
Nakagama reasons that with the 30-year Treasury returning 9.70 percent, and with a real interest rate of around 3.0 percent, the market is assuming an inflation rate of 6.7 percent. Since he is forecasting an inflation rate of 3.5 percent for all of 1987, he believes there is room for interest rates to decline over the next few months.
Nakagama said the lower inflation rate will result from the decline in oil prices, lower cattle and hog prices, and the moderation of other key commodity prices.
In addition, Nakagama believes that meaningful action will be taken by Congress and the administration in reducing the federal budget deficit.
Other reasons for rates to decline include weak sales in interest rate-sensitive sectors of the economy (housing and auto sales), a sizable improvement in the trade balance in September (to be released in November) with the deficit coming in around $12 billion to $13 billion, and protectionist trade legislation that can be expected to produce a stronger dollar and a weakening of key foreign currencies.
Nakagama sees as a major problem the fact that Americans are borrowing to finance consumption. In his latest market letter, he noted that one of the basic tenets of "supply-side" economics was that it was supposed to increase personal savings. "Personal savings as a percentage of disposable income has fallen from an average of 7.1 percent in the 1978-1981 period to 3.6 percent in the latest one-year period and to 3.0 percent in the second quarter of 1987.
"Over the same period, the consumption share of the gross national product has risen from 62.8 percent in the 1978-1981 period to a new peak of 66.2 percent of GNP. This is precisely why the United States is running such a huge trade deficit. The American people are spending a record share of their incomes on consumption expenditures while going ever more deeply in debt. And more and more of that debt is ultimately owed to foreign creditors, especially Japan."
James E. Lebherz has 28 years' experience in fixed-income investments.