Op-Ed: Are bond markets turning on the White House?

  • Falling bond yields are recession signals
  • Bond markets see the limits of the Fed's solo actions
  • Bond markets don't believe the economic growth agenda

It's not a good idea to dismiss the falling bond yields in reaction to the Fed's difficult work of steering the U.S. economy in an environment of rising uncertainties with respect to (a) fiscal management, (b) trade policies, (c) infrastructure investments and (e) structural reforms.

With all these question marks clouding the Fed's operating horizon, saying that America's monetary authorities are flying blind could be a bit of an understatement.

There are three simple interpretations of bond market's signals.

First, the bond market sees that the Fed is driving an already weak and somewhat deflationary economy into a recession by initiating a credit tightening process. That is bad for corporate profits and a richly-valued equity market, but it raises the demand for default-free government bonds.

Second, a more sophisticated version of the preceding argument is one of the policy concepts in the expectations theory: Bond markets feel confident about the Fed's unshakable commitment to price stability, even at the cost of the sharply slowing economic activity and rising unemployment.

Third, you can call this one a bond market "I told you so" argument: A vote of no confidence in promises of (a) tax cuts, (b) a tax-induced manufacturing boom (including repatriation of outsourced production capacities), (c) massive infrastructure investments, (d) foreign trade changes to level the playing field for exporters and import-competing industries and (e) a slew of structural reforms to make America's markets more productive and competitive on a world scale.

Say it ain't so, Mr. President

The first two outcomes are the mainstream economics of financial markets. But the third possibility – based on an alleged loss of confidence in the government's ability to make good on its key policy options – is the most dangerous aspect of recently rising bond prices. In this particular case, markets seem to be betting on the failure of unrealistic promises made by an administration left twisting in the wind by its Congressional majority.

The former Wall Street operatives working for the administration should be aware of an urgent need to reassure the markets about the economic agenda and the progress – if any – in its implementation. They should also realize that concrete and deliverable measures to improve jobs, incomes, health care and education are the best channels to connect with the American people, raise the approval ratings and fight alleged attempts to paralyze the executive authority.

Instead of that, the monetary policy is stuck with the best-case scenario of a 2 percent economic growth for the rest of the year, and beyond, and an inflation rate within the target range of 0-2 percent. In its apparent anticipation of no help from fiscal, trade and structural policies that is the best the Fed alone can do to keep the economy afloat for the seventh consecutive year.

That is probably also why the Fed has not been doing much to shrink its bloated balance sheet.

At the end of May, the monetary base stood 6.9 percent above its December 2016 level. During the same period, excess reserves (i.e., loanable funds) of the banking sector soared 9.6 percent to a staggering $2.1 trillion.

Lending to consumers remains brisk and sustained. The total credit extended to consumers in the year to March was growing at an average annual rate of 6.3 percent. Commercial banks account for 40 percent of that total, and their lending to households, over the same interval, marked a 7 percent increase.

In view of that, it makes little sense to get excited about future credit tightening speculations. The last 25 basis point increase in the federal funds rate still leaves the only interest rate the Fed directly controls at a negative -0.74 percent in real terms. That is a very easy credit stance indeed.

Assuming an inflation rate (measured by the CPI) of about 2 percent, it would take four additional interest rate increases of 0.25 percent to roughly reach the area of neutral monetary policy.

So, yes, the Fed is soldiering on, but the U.S. economy will underperform as long as it continues to move along solely on monetary policy and a woefully unbalanced policy mix.

The Fed, therefore, may wish to temper its "mission accomplished" enthusiasm. Exulting about a 4.3 percent unemployment rate and "tightening labor markets" is inappropriate. With 40 percent of active civilian labor force out of the market, and 13.6 million people -- double the officially reported number – without a job, or stable employment, tightening labor market claims are specious and insensitive.

There certainly can be a lack of skilled labor in some industries, but with these numbers of excess supply there cannot be any tightening of the overall labor market. If that were the case, labor costs would be rising instead of declining. Last year, nominal hourly compensations decreased to 2.5 percent from 3 percent in 2015, marking a further weakening in the first five months of 2017.

Investment thoughts

By pushing bond yields down, markets are betting on the failure of administration's promises to stimulate the economy with personal and corporate tax cuts, infrastructure investments, trade policy changes and structural reforms.

The White House and the Congressional Republicans should dispel these fears with a credible report on where things stand with respect to key economic policy issues.

If that were done, market fundamentals would reassert their role in driving asset prices. But if a significant flattening of the yield curve is ignored, a portfolio shift could smash the rally in fully-valued equity markets.

New liquidity provisions by the Fed might help to limit the damage, but that would not change an unfavorable economic growth outlook.

A coordinated troika effort is essential. America's economic growth crucially depends on the ability of the Congress, the White House and the Fed to balance out the combination of fiscal, monetary, foreign trade and structural policies.

The White House must take the lead to reassure the markets that its economic agenda is on course -- and that it is being implemented.