Op-Ed: Fed temporarily cows the vigilantes, but 'hitting somebody' is no substitute for effective policies

The Eccles Building, location of the Board of Governors of the Federal Reserve System and of the Federal Open Market Committee, June 2, 2016 in Washington, DC.
Brooks Kraft | Getty Images
The Eccles Building, location of the Board of Governors of the Federal Reserve System and of the Federal Open Market Committee, June 2, 2016 in Washington, DC.

Looking at the bond market's rapidly sinking yields you might think we are again celebrating the "goldilocks" return.

Unless you think that this is just the usual portfolio shift. The problem with that view is that it assumes a portfolio preference driven by expectations of an inexorably recession-bound economy, or by an impending Armageddon (Middle East, Northeast Asia, etc.) that will somehow spare bonds while killing equities.

Dark scenarios indeed. How about looking at something "boring" like the universal law of price discovery through forces of demand and supply?

For example, during the first quarter of this year the Fed's monetary base exploded with the credit creation (i.e., buying bonds in exchange for cash) to the tune of $324.7 billion, most probably an unprecedented such event since America got its central bank almost 104 years ago.

People and institutions lending their savings to Uncle Sam can be very grateful for the Fed's largesse: A nearly 40 basis point decline of yields on the benchmark ten-year Treasury note in the first three-and-a-half months of this year is a nice return. And, given the Fed's stated intention to let the economy "coast along" its 1.5-2.0 percent growth path, Treasury's creditors may still be tempted to part with more of their loanable funds.

Maybe they will. But an investor, as opposed to the in-and-out bond trader, might wish to take a deep breath and think again about a proposition assuming zero inflation premiums on Treasury's long-term instruments that are now offering zero or negative real returns.

At any rate, the Fed's huge bond purchases have cowed, for the time being, the proverbial bond market vigilantes – an unmistakably ominous sign indicating that the eagle-eyed vigils are taking the rapidly sinking bond yields as a clear path of an economy going down the tube.

What? The former Wall Street colleagues of the bond traders advising the White House going sour on the election-winning slogan "Make America Great Again?"

Maybe the media reports about an imminent cleanup in the president's entourage are not "fake news" after all.

But here is another media report I hope is true. In one of his latest policy reversals -- officially known as "intentionally unpredictable policy changes" -- the U.S. president is allegedly warming up to the Fed's current leadership. If true, that is the best thing the president could do for himself, the economy and the financial markets.

I have always thought that this new administration should seek, and follow, the recommendations of the Fed's research staff. That would be good for the president's political viability, and for passing the decisive test posed by next year's Congressional mid-term elections. Yes, a coherent economic policy is a tough, patient and disciplined work that has nothing to do with Wall Street's high-speed trading.

An effective coordination with the Fed is the only guarantee that the economic policy mix --monetary, fiscal, structural and foreign trade -- will work in a stable and mutually reinforcing manner. Only the Fed can give the president an unbiased view of his policy constraints – if he wants his proposed fiscal, structural and trade changes to operate in an environment that the monetary policy can support, without compromising its price stability mandate.

There is no room for a deficit-neutral, large fiscal easing in an economy experiencing a total public sector budget gap of 5 percent of GDP, a public debt/GDP ratio of 116 percent and a primary budget deficit of 1 percent of GDP.

Debts and deficits without tears is a dangerous fairy tale. A deficit-funded increasing purchasing power raises price pressures in labor and product markets and jacks up the public sector borrowing requirement. That, in turn, forces the Fed to initiate a credit tightening process, with ensuing losses in financial and real estate assets. The way then is perfectly paved for recessions of ex-ante unknowable amplitude and duration.

Structural and foreign trade policies also have a heavy bearing on growth, employment, inflation and the stability of financial markets.

Trade issues, in particular, bring another complication because they inevitably get mixed up in the general context of foreign policy and exacerbate acute security concerns. China, of course, was at the core of that trade-security nexus. But nobody expected that Europe would be incensed by suspicions that the U.S. was about to strike deals with China and Russia that would relegate the E.U. to the position of global insignificance.

As a result of that, the Europeans are now putting trade problems to the side while they celebrate America's caricature as an old cop returning to his world beat. They are condescendingly laughing at the U.S. at the sounds of "we told you so" refrains.

The most influential French daily runs a headline "Trump is completing his evolution," explaining that "America's Deep State" has forced him into humiliating and total policy turnarounds. Germans find all that exactly as they expected, emphasizing ongoing problems created by chaotic and undependable U.S. policies. The British are "hazarding" the view that Washington should not be looking for trouble with adversaries running huge nuclear arsenals – a "novel" geostrategic thinking indeed. The only places where we still get some favorable reviews are Poland and Baltic States, mainly because they want us to keep the Russians at bay.

Most other Europeans are deeply alarmed about Washington's alleged return to its old-style "hit somebody" policy. They see that as a flagrant retreat from the solemn pledge President Trump gave to American people in his inaugural address. They are also rationalizing that about-face by the president's allegedly futile attempt (a) to placate the sworn enemies in his own party, and (b) to deflect attention from his troubled agenda with regard to healthcare, budget issues and foreign trade.

Investment thoughts

The best news is that the White House is apparently realizing the merit of the Fed's lonely job in trying to hold together an unbalanced and seriously mismanaged U.S. economy.

The caveat here is that the Fed is far from infallible and immune to unacceptable outside influences. Please remember that all the Fed has done since the financial crisis in 2008 is a correction of its own huge errors of credit policy and bank supervision. The reputable and trustworthy chroniclers of Washington life have amply covered these issues, without being contradicted by the Fed's leaders who got the country into the most serious financial crisis since the Great Depression.

We all have to hope that the Fed will not get us into the same, or worse, situation again.

But we shall soon know. The key issue is a budget draft to be announced in the weeks ahead. That will immediately give a clear outlook for credit stance, growth and inflation.

Trade problems may also prove to be more difficult than thought by the new administration, partly because they are in some important cases inseparable from geostrategic concerns. Trade imbalances with Japan and South Korea -- a total of $97 billion in 2016 – are the prime examples of that.

For similar reasons, one might expect a less strident approach with respect to China. Some American companies are also voicing concerns about the structural nature of trade issues with Beijing. These concerns are well founded; they will probably lead China to work around them by increasing imports from the U.S. while diversifying its export destinations to show a steadily narrowing U.S.-China trade imbalance.

Germans are announcing the same trade strategy. Berlin is already actively working on alternatives to its large American sales.

What we got left is the Fed – the indefatigable QE market driver, generating moderate real economy gains and facing, quite possibly, the end of that particular policy trail. After months of threatening a long-overdue normalization of its bloated balance sheet, the Fed's monetary base at the end of March was still roughly where it was a year ago.

That may well mean that waves of fresh credit avalanches could soon hit the wall. Markets, therefore, need to see fiscal, structural and trade policies that can support high valuations and the expected earnings potential.

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