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Bond rout coming as growth recovers

Bond traders at CME Group
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Betting against the effectiveness of an extraordinary monetary stimulus is never a good idea. A reportedly large buying bout into the latest bond market rout is a case in point.

The U.S. economy is in good shape. It is poised to accelerate in a way that will surprise those who told the University of Michigan pollsters last week that they expected an inflation rate of 2.6 percent over the next five to ten years.

One wonders whether these were the same Americans whose medical costs over the last twelve months rose 4.2 percent, along with a 3 percent increase for rents, 2.4 percent for services and 2.3 percent for groceries.

Or maybe these were the people with a chronic case of money illusion whose nominal compensations in the year to March increased 2.6 percent?

Whatever it is, it seems unwise to bet on a weak and stagnant U.S. economy in the months and years ahead based on a quarterly decline of investments and a strongly negative effect of incomplete foreign trade numbers in the first three months of this year.

Take another look

A completely different picture emerges when one looks at the growth dynamics of the U.S. economy over the several past quarters. Between the first three months of 2014 and the same period of this year, the economy grew at an annual rate of 2.7 percent, accelerating to a 3 percent growth rate in the most recent quarter.

How significant is that?

Over the last 24 years, the U.S. economy has grown at an average annual rate of 2.6 percent (exceeding the developed world's average of 2.2 percent). That means that America's 2.7 percent growth rate observed over the most recent twelve-month period is consistent with its long-term averages, which include the peaks in the 1990s and the Great Recession troughs of 2008 and 2009.

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Can we do better? Is that 2.7 percent growth rate fast enough?

Measured against the physical limits to growth, defined by capital and labor resources, the actual growth rate of 2.7 percent is significantly above the U.S. economy's estimated growth potential (i.e., a noninflationary growth rate) of about 2 percent.

The possibility that we may be growing at an unsustainably fast pace is a source of alarm to many observers, including some U.S. Federal Reserve (Fed) governors who have been urging for a long time an immediate shift toward rising interest rates.

But that view is far from being widely shared. These governors have been consistently overruled by the Fed's rate setting committee (Federal Open Market Committee – FOMC). Following the FOMC's session last week, the Fed announced no policy change, pointing out that the process of interest rate adjustment will have to wait for further labor market improvements and the inflation's movement closer to its 2 percent target (from a negative 0.1 percent in March).

The Fed's actual operation is entirely consistent with that wait-and-see attitude. The central bank's monetary base has been roughly stable over the last two months, and the effective federal funds rate closed last Friday at 0.13 percent, well below its 0.25 percent target.

Crying wolf

It is difficult to see how the Fed could justify rising interest rates at a time when inflation has turned slightly negative – even if that is a result of large and transitory declines of energy prices – and the actual unemployment rate remains at more than 11 percent.

Under these circumstances, arguments for anticipatory monetary tightening are hard to sustain in spite of their empirically documented validity. Here are some of these arguments to give a little perspective to the current bond market pricing.

First, there is a well-known difficulty of long and variable lags in the impact of monetary policy. Depending on the structure of the economy and the efficiency of the financial system, these lags can take more than a year to register the impact of interest rate changes on private consumption, housing demand and business investments. These lags are also the basis of indisputable claims that periods of recession and high inflation are always created by errors of monetary policy, because the stimulus (tightness) is maintained well past the point where the economy needs it.

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In other words, the monetary authority would have to be endowed with perfect foresight or – which amounts to the same thing -- to systematically enjoy an extraordinary good luck in its guesses of where the economy is at the time of policy change, and where the economy will be when the policy change begins to affect demand, employment and price stability.

Second, if the economy continues to operate above its noninflationary potential – as is apparently the case now – costs and prices will keep pushing up. There is already some evidence of that. For example, the rate of growth of employment costs for private sector workers in March nearly doubled from the year ago to 2.8 percent. With labor productivity gains of only 0.7 percent in 2014, profit margins will be squeezed. That will prompt businesses to raise prices because price hikes will stick in a growing economy. And that's how the process of accelerating price inflation gets on its way …

Hence an old adage: you can't wait to see the white of the eye of inflation to start raising interest rates.

Investment thoughts

Driven by low credit costs and increasing jobs and incomes, the U.S. economy is poised to accelerate in the months ahead.

Fixed-income assets have not been my preferred portfolio choice for quite some time. But I do like U.S. equity markets. Even for those inclined to favor defensive postures, America's world beating companies offer excellent hedges and long-term profit opportunities.

At current prices, gold is also an attractive investment.