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Real Growth Is The Real Story
Behind the Treasury-bond collapse.


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Larry Kudlow

Monday’s Wall Street Journal tried to argue that the headline-making Treasury-bond sell-off is “technical” and does not infer stronger economic growth. Consider this analysis par for the course. These days it seems that nothing can sway the major media into believing that a more robust recovery is on the way.

Since June 3, the bellwether Treasury bond that matures in 10 years has lost nearly 10 percent in price as its yield unexpectedly jumped to 4.3 percent from 3.1 percent. Bond rates typically rise during recoveries and fall in recessions. During the economic and stock market slump that began in early 2000, Treasury rates plummeted to nearly 3 percent from almost 7 percent.

Now, there’s a hitch in the recent Treasury development. Beginning last May, Federal Reserve Chairman Alan Greenspan argued that to ward off deflation, the Fed might make special purchases of Treasury bonds and thereby inject more cash into the financial system. This caused bond prices to rise temporarily and yields fell. But in congressional testimony earlier this month, he completely backed off this position, sucker-punching the Treasury market and contributing to a rout in bond prices. Call this Alan Greenspan’s head-fake bond bungle.

But that aside, the Treasury collapse — and the current rise in real interest rates — does infer stronger economic growth.

Economists used to use static snapshots to identify real bond yields, subtracting the inflation rate from the Treasury market rate. But now the market for TIPS — Treasury Inflation-Protection Securities — makes it possible to capture real interest-rate expectations.

So, because of the TIPS market — where yields have risen to around 2¼ percent from under 1½ percent — we know that nearly all of the recent nominal rise in the 10-year Treasury has been absorbed by a near-comparable real rate rise. Putting it another way, the rise in real interest rates is for real. And rising real interest rates are a clear indicator of stronger investment and economic growth.

Even while Greenspan was shooting off at the lip about special Treasury-bond purchases (still a reasonable way to add cash and decontrol the federal funds target rate), a big tax cut on investment was passed into law in Washington. In a significant way, the Bush tax cut boosted real interest rates.

The trouble is, most reporters dismiss a tax cut as just another thing that raises budget deficits. They don’t recognize that broad-based tax cuts lead to higher after-tax investment returns and a reduced cost of business capital.

There no longer seems to be any doubt that a new cycle of stronger investment and economic growth lies ahead. Evidence of this can be seen vividly in commodities. The price of gold, which was just over $300 a year ago, has run up nearly $25 to $367. At this stage of the nascent business-recovery cycle, a higher gold price serves as both an indicator of liquidity and a harbinger of faster-paced economic activity.

Silver, copper, platinum, and the metals indexes are also on the rise. And the S&P stock market baskets for industrials and basic materials have moved into the top-five performing sectors. Along with consumer spending, these are all cyclical indicators of stronger future economic growth.

With 64 percent of the S&P 500 companies reporting second-quarter results so far, profits and earnings are up over year-ago levels and are coming in higher than expectations. Surely this good news is contributing to the improved economic-growth forecast that is taking place in the TIPS and commodity areas.

Before long the mainstream media will give up the real-recovery-is-not-coming view. But rather than crediting the Bush tax cut, or the inherent dynamics of the productivity-enhanced economy, look for reporters to lurch into a new demand-side mantra that rising inflation is on the way.

This predictable growth-causes-inflation nonsense will again overlook several key points that are well established in economic history. First, lower tax rates are always associated with declining inflation. Second, increasing productivity raises real output and reduces inflation. Third, economic growth itself is usually associated with lower inflation. As with tax cuts and productivity, increased growth absorbs any inflationary excesses of liquidity that might exist in the financial system.

Indeed, as the economy starts to fire on all cylinders, it is essential that the Fed keep pouring in new cash to fully accommodate economic recovery. The U.S. is now poised to defeat deflationary recession with a tax-cut-led policy of reflationary recovery. And the American example should positively influence the moribund economies of Western Europe and Japan.

Who knows, within a few months some reporters may even be heralding a growth-led decline in the budget deficit. Supply-siders will have to hold their tongues in order to avoid crowing, “We told you so.”

Mr. Kudlow is CEO of Kudlow & Co.



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