US bond market vigilantes have 'gone fishing'

Martin Leissl | Bloomberg | Getty Images

It seems like they did manage to put up that famous leave sign before delegating to market timers the guessing game of the anticipated rate hikes.

Vigilantes are the foot soldiers of the interest rate formation process. They are feared because they vote with their feet on the credibility of monetary policies. By flagging the danger of rising inflationary expectations, they are warning people to review their economic behavior and their portfolio preferences.

So, what does the "gone fishing" sign tell us? It's just a simple message to let us know that these keen observers of the U.S. dollar's real purchasing power are perfectly happy with the current policies of the Federal Reserve (Fed).

Here is an example to explain the technicalities of this rare bliss.

A long-term interest rate (or a bond yield) consists of two parts: a real interest rate plus inflation expectations. A real interest rate is roughly approximated by the potential growth rate of the economy, while inflation expectations set the price investors will demand for holding long-term fixed-income assets.

Quiescent inflation expectations

To illustrate this, consider a 1.93 percent yield investors were asking last Friday to hold the Treasury's ten-year note. If you accept the consensus view that the potential growth rate of the U.S. economy is now somewhere in the range of 1.5-2.0 percent, you will inevitably conclude that inflation expectations are virtually zero. In other words, bond market investors are willing to hold Uncle Sam's ten-year paper with little, if any, inflation premium.

That explains why bond market vigilantes have "gone fishing" -- despite the four-fold increase of the Fed's monetary base over the last six years, and an inflation dynamite of $2.6 trillion in excess reserves (funds banks can readily lend) the U.S. banking system was holding as of March 18, 2015.

Is it time, then, for vigilantes to go back to the watchtower?

It depends where the watchtower is. If you are observing the situation from a purely U.S. point of view, you might suspect that a zero inflation premium on a ten-year loan to the government is probably an imprudent investment.

Here are a few reasons that could underlie such a concern.

You are looking here at an economy that is hitting against the physical limits of its capital and labor resources even at a relatively modest growth rate of 2.4 percent. Unit labor costs (a floor below the general price inflation) have accelerated last year to 1.8 percent from 0.2 percent in 2013, and inflation in the service sector -- about 90 percent of the U.S. economy that is largely sheltered from international competition -- is stuck in the range of 2.5-3.0 percent. Food prices in January rose 3.2 percent from the year earlier, and the core CPI (a measure that excludes food and energy) showed an annual increase of 1.6 percent only thanks to a 19.6 percent collapse of energy prices.

For a prudent U.S.-based investor, these are very close inflation calls – enough to make one think more than twice about lending ten-year money at a zero inflation premium.

America's huge capital inflows

The picture, however, is quite different from the viewpoint of non-resident investors, as witnessed by a soaring demand for U.S. assets. One can see that from the dollar's 22 percent trade-weighted appreciation over the last twelve months and from a 6.4 percent increase in the overseas demand for Treasury securities in the year to January.

Think of it: you have a choice between a dollar-denominated instrument backed up by the "full faith and credit" of the United States and public sector assets of virtually bankrupt governments labeled in a currency whose viability is under a constant question mark.

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That choice, the dollar's extraordinary strength -- underpinned by an increasing foreign demand for a wide range of U.S. assets -- and the Fed's attempt to moderate the dollar shortage on global markets is what sent vigilantes fishing.

Obviously, that is also the reason why the Fed is in no hurry to stoke an already strong world demand for dollars by raising the nominal yields on greenback instruments.

Investment thoughts

The growing economic and political chaos in Europe will continue to make U.S. assets relatively more attractive to international investors.

But to maintain and enhance the intrinsic value of American markets for goods and services, it might be a good idea to review the wisdom of using impediments to trade and financial transactions as an instrument of diplomacy. Recent examples of some of our close allies declining to follow us in such pursuits are serious warning signs.

U.S. equities are much safer investment bets than fixed-income assets. In a growing economy, equities will be more resilient than bonds during a long-overdue process of interest rate normalization.

Michael Ivanovitch writes about world economy, geopolitics and investment strategy: @msiglobal9