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Fed, Bond Market Tango to Get Hotter

David Sanger | Digital Vision | Getty Images

Here is why rising U.S. bond yields are arguably the most meaningful policy feedback the Federal Reserve might be looking for.

It is the correct market response to an extraordinarily loose monetary policy in a growing economy. Unfolding portfolio shifts are reflecting changing views of asset valuations. And, perhaps most importantly, expectations of rising capacity utilization rates in labor and product markets – shown by increasing nominal returns on fixed income assets – are setting up clear markers for future credit policy changes.

Briefly put, the Fed is getting a reliable signal that its policy is working.

This subtle dance offers an important advantage: Markets can continue to adjust in anticipation of a policy change without major disruptions, especially if the Fed encourages, and guides, these adjustments with occasional hints of policy intent.

Winks and Nods

That is what the Fed has been doing ever since its commitment to no policy change before the unemployment rate was brought down to 6.5 percent in 2015 began to look increasingly tenuous. As dissenting views about that got louder and more frequent within the Fed's interest rate setting forum (Federal Open Market Committee – FOMC), the recent reaffirmation of the usual data-driven policy procedures became inevitable.

Obviously, that was not lost on bond markets. They were now back on the same page with the Fed, reading the same price and activity indicators, with attention focused on employment numbers.

And markets are reading correctly. Responding to signs that improving U.S. economy may no longer need excessive monetary stimulation, yields on the 10-year Treasury note were driven up, since mid-April, by more than 40 basis points to 2.13 percent. Last week's trading sessions are also pointing out that the yields' upward trend remains strong.

What did the Fed do? Nothing. Holding its effective federal funds rate at 0.08 percent, way below the 0.25 percent target, the Fed is signaling that it is much too early to begin a gradual move toward less accommodative credit conditions.

(Read More: Junk Bond Volume Piling Up, but Trouble Lurks)

It looks like the Fed and the bond markets are sizing each other up, with the Fed confidently standing back, letting some air out, and watching the markets correct their liquidity-driven trades and their exaggerated pessimism about the economy.

The music is on though and the dance of these two wary partners will get hotter and more exciting in the months ahead. The bond markets' steamroller will be difficult to turn. Only inflation-benign data and moderate growth of output and employment could slow it down. The Fed's part will be tougher; it will have to play a creative game while inventing new steps to a leaner balance sheet and smaller excess reserves.

A Firm and Steady Hand on the Tiller

The Fed's main guiding light is a seriously underperforming U.S. economy. The average growth rate of 2 percent since the recovery began in late 2009 is between 1 and 1.5 percentage points below the economy's noninflationary growth potential. That is still the case if the observation period is limited to the last four quarters.

Economists have fancy names for the difference between the actual and potential output of an economy, but this economist will simply call it a huge and saddening waste of the country's human and physical capital.I am sure that even the policy hawks on the FOMC are not indifferent to this distressing truth.

They are disagreeing with their dovish colleagues about the likely impact of the monetary stimulus we have had in the economic system since the late 2008. They fear that, sometime in the future, this stimulus will create too much of a good thing: strongly rising jobs and incomes, excessive capacity pressures and a runaway inflation whose control would eventually lead to a recessionary relapse.

(Read More: Bernanke Jokes About His Future in Princeton Speech)

At the moment, that is an unfounded fear. We are nowhere close to Mae West's nirvana: "too much of a good thing can be wonderful." The huge slack in labor markets has driven down real hourly compensations 0.6 percent in the year to the first quarter. As a result, unit labor costs – approximately 75 percent of all production costs and the floor below any inflation rate – are continuing to grow at an annual rate of less than 1 percent.

That is good for corporate incomes, as shown by net profits' 6 percent year-on-year gain in the first quarter – after an average 6.3 percent increase in 2011 and 2012. One can expect that growing profits will lead to rising investments and greater job creation. The few Fed hawks know that this is part of the virtuous process rather than a destabilizing economic development.

All this indicates that the data-driven Fed will have plenty of time to begin a shift toward gradually tighter credit policies before the economy reaches its growth potential. But there won't be any free passes here. The Fed will be constantly tested by bond market vigilantes. I expect them to maintain their poise, but they may well slow their swing.

My earlier view on investment strategy is roughly unchanged: Sell bonds, buy equities and leave gold alone (this is new) - if you want to own many of the world beating companies.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also 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.

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