Bond markets and Fed in uneasy dialogue

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The slowing expansion of the U.S. Federal Reserve's (Fed) balance sheet, a continuing drawdown of banks' excess reserves and rising long-term interest rates indicate that the wary dialogue between bond markets and the monetary policy has entered uncharted territory.

At the end of May, the Fed's $3.9 trillion monetary base (a four-fold increase from pre-crisis levels) was only $14.8 billion above its level at the beginning of this year, and its annual growth rate has virtually ground to a halt.

Banks' extraordinarily large loanable funds of $2.5 trillion (in 'normal' times they are $1.5-$2 billion) are showing a more pronounced slowing pattern: they are down $31.9 billion in the first five months of this year and 2.4 percent below the level of May 2014.

Bond markets have reacted to these liquidity contractions by pushing up the yields on long-term securities. Last Friday, the 2.39 percent yield on the benchmark ten-year Treasury note was 71 basis points above its most recent record-low level in early February.

By raising the longer end of the yield curve, bond investors are anticipating the beginning of the Fed's tightening process, even though the Fed's policy interest rate – the cost of overnight money – still continues to fluctuate around half of its 0.25 percent official target.

Don't believe the declinists

Being the key lenders to the government, bond markets are constantly adjusting their views of the monetary policy. They do that by changing the nominal yields they demand to cover the expected risks to real returns on their loans to the U.S. Treasury.

Fed rate liftoff is a market opportunity: Pro
Fed rate liftoff is a market opportunity: Pro   

That is the meaning of a frequently heard market comment that rising bond yields are a vote of no confidence in the central bank's commitment to price stability, usually defined as an inflation rate of 0-2 percent.

Bond markets, therefore, make their own assessments of the monetary policy in relation to that particular inflation objective over relevant investment horizons.

If, for example, bond markets believed the widely publicized views that the Fed's policy was unable to extricate the U.S. economy from an allegedly irreversible stagnation, long-term interest rates would be falling rather than rising.

Bond yields would also be falling (instead of rising) if markets believed that the current jobless rate of 5.5 percent was more than an entire percentage point higher than the Fed's 4.3 percent estimate of the full-employment unemployment rate. Incidentally, that unemployment rate is also called "non-accelerating inflation rate of unemployment" (NAIRU).

Markets, obviously, don't believe any of that – and with good reason. Here is why.

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Over the last four quarters, the U.S. economy has grown at an average annual rate of 2.5 percent.

Is that an irreversible stagnation? The answer is no.

The growth rate of 2.5 percent we are now experiencing is almost exactly identical to the 2.6 percent average growth rate of the American economy over the last 24 years – a period during which the developed world's average economic growth was 2.2 percent. Indeed, America's 2.5 percent growth rate is consistent with its long-term average, which includes the peaks in the 1990s and the Great Recession troughs of 2008 and 2009.

Bond vigilantes are back

Proponents of the stagnation hypothesis are also ignoring the fact that America's current growth rate is substantially above the economy's growth potential of 1.8 percent (roughly the sum of productivity and the labor force growth) estimated over the five-year period since 2010.

These physical limits to growth are what declinists should worry about. That is a good issue to put forward in the unfolding presidential election campaign, because only investments in education and technology can lift the productive potential of American economy.

Why the Fed will hike rates in September
Why the Fed will hike rates in September   

The evidence that the actual growth rate exceeds by 0.7 percent the limits to noninflationary growth set by labor and physical capital resources also puts a big question mark over the Fed's estimate that the "natural" (NAIRU) unemployment rate is 4.3 percent – a far cry from the 5.5 percent rate observed in May.

If that was a plausible estimate, wages and general labor costs would be falling because of the implied excess supply of labor. But that is not what we are seeing.

Compensations in the private industry accelerated to an annual rate of 2.8 percent in March from 1.7 percent a year earlier. Unit labor costs (usually considered as a floor to any given inflation rate) increased 1.8 percent in the year to the first quarter, more than double the rate of increase in the previous four-quarter period.

Bond markets see all that. Their actions suggest that they don't believe that there is a huge labor market slack in an economy growing substantially above its noninflationary potential. And neither are they paying much attention to a slight dip in April's CPI as a result of collapsing energy and import prices (-19.4 percent and -10.7 percent, respectively).

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Bond investors know that the core inflation rate (CPI less food and energy) hit 1.8 percent in April – a number in the upper range of the Fed's 0-2 percent medium-term inflation target. They are, therefore, demanding higher bond yields to protect themselves, and they see no reason to wait, as the Fed says, "to be reasonably confident that inflation will move back to 2 percent over the medium term." We are there already, and we have been there since the middle of last year.

Investment thoughts

Pushing up the long-term interest rates, bond markets are challenging the Fed to implement a policy consistent with rising cost and price pressures in an economy advancing substantially above its physical limits to growth.

A further steepening of the term structure is likely to force the Fed's hand by unleashing waves of yield arbitrage. If that were to happen, it would greatly limit the Fed's ability to operate as a stabilizing residual bond buyer. That would also make it difficult for the Fed to initiate its overdue process of interest rate normalization in an orderly manner.

Bond market vigilantes are back. And they are here to stay.

Michael Ivanovitch is an independent analyst focusing on world economy, geopolitics and investment strategy. He served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia Business School.