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August
1, 2003, 7:00 a.m. |
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popular
argument making its way around the financial community is that the rise
in bond yields and interest rates could undo the economic recovery. I
hadn't paid much attention to the argument until I read the following
headline on the front page of the Wall Street Journal:
Bond-Market Rout Could Pose Hurdle to Economic Recovery.
The front page of the Journal is a good barometer of what's on the minds of members of the financial community. So, let's investigate this position.
First, why the rise in bond yields? Here are three possibilities:1. Rising expectations of inflation. 2. The ballooning budget deficit. 3. The belief that the economy is recovering.Fortunately, there is an ample amount of market data to rule out the first two possibilities (which are sadly the darlings of the financial press). Nope, It's Not Inflation. An inflation target of 2 to 3 percent is a good characterization of the Fed’s behavior during the last two decades. So, an inflation rate below the 2 percent rate is evidence of the Fed pushing the economy to the brink of deflation, and a figure in excess of 3 percent means the economy is headed into a slight inflationary spiral. The data supports the view that Alan Greenspan brought the economy to the brink of deflation. Since 2001, the inflation outlook recovered somewhat as expected inflation rose to the 2 percent range. More recently the outlook calls for expected inflation in the 2 to 3 percent range over the next 10 years. (In a forward-looking market, the difference between the yield on 10-year government notes and 10-year Treasury-indexed notes, or TIPS, provide the markets with a proxy for the inflation expectations over the life of bond contracts. In other words, expected inflation can be derived from the difference in yield between the 10-year notes and the 10-year TIPS.) So, one is hard pressed to argue that an inflation expectation of less than 3 percent is signaling an inflationary problem in the future. Thus, the recent surge in bond yields is not due to concerns about inflation. The rising bond yields signal a rise in the real interest rate. Nope, It's Not the Budget Deficit. The belief that budget deficits lead to higher interest rates is widely held among investors and economists. Surprisingly, there is little or no empirical evidence supporting this view of the world. During the 1980s, bond yields trended downwards even during the two episodes of deficit deterioration — the phase-in of the Reagan tax-rate cuts and the Bush Sr. tax increase. The last ten years offer additional evidence of the lack of a positive relationship. Bond yields trended down during periods of improvement and deterioration of budgetary conditions. Looking at the last twenty years, it is fairly obvious that the best way to characterize bond yields is that they trended downwards irrespective of budgetary conditions. Yes — It's the Recovery! By process of elimination, the rising Treasury rates must be due to a recovering economy. Which leads to another point: If rising rates are the result of the recovery, isn't it silly to argue that rising interest rates pose a threat to the recovery? The rising rates are a result of an outward shift in aggregate demand in the economy, and the major source of the shift is the George W. Bush tax-rate cuts. Since inflation is under control, the rise in interest rates are part of a market-equilibrating process. But that's not all: During periods of falling interest rates, when rates are expected to fall further, purchases of consumer durables will be less than they would otherwise be. This explains the weak economic performance of the last couple of years. In the same way, expectations of higher interest rates will lead rational investors and consumers to accelerate their purchases of consumer durables. The expectation of rising rates leads to an additional shift in aggregate demand, adding short-term fuel to the economic recovery. Economic data on consumer durables in recent days supports this view that the economy is gaining strength in the face of rising interest rates. Contrary to what many analysts are saying, the rise in real rates is a harbinger of good things to come.