Politics & Policy

Cutting Through the Bond Bull

What to think about interest rates and the perennial doom-and-gloomers.

It is becoming increasingly clear that the U.S. economy is emerging from a brief lull and resuming growth on par with the plus-3 percent annual rates that had been the norm since the mid-2003 enactment of President Bush’s tax cuts on capital formation. A string of data on manufacturing, business investment, consumer spending, and inventories all point to a hearty reacceleration from the paltry 0.6 percent growth rate recorded in the first quarter, despite the continued drag from housing. There’s little reason to think the resumption of a robust pace of expansion won’t be sustained for at least the next several quarters.

This is good news for just about everyone — except the dour bond-market habitués.

Bond purveyors have bought into all the hype about the economy being near free fall. In March, the economic nay-saying reached fever pitch, driving the rate on the benchmark 10-year Treasury bond below 4.5 percent on the supposition that the Federal Reserve would undertake a series of rate cuts to combat a deterioration of economic growth. These bond bulls are now licking their wounds: Since early May, with an economic reemergence becoming increasingly difficult to deny, the 10-year interest rate has soared above 5 percent.

As might be expected, however, the prophets of gloom haven’t completely given up. The meltdown of the sub-prime mortgage market — and most recently the near collapse of the Bear Stearns hedge funds that are heavily invested in sub-prime assets — has given the bond market a short-term bounce. Albeit an outside chance, this crisis could spread, compelling the Fed to cut rates in an effort to bailout failing financial institutions.

And while the interest-rate reversal is largely the result of growth rebounding to vibrant levels, some in the doom-and-gloom crowd are attempting to peddle the idea that this backup in rates will itself have the effect of throwing the economy off track.

Not likely.

Interest rates have normalized from unsustainably low levels brought on by a dubious view of the economic outlook. At current levels, long-term rates are essentially equilibrating with the Fed’s current overnight rate target of 5.25 percent. An abundance of data covering commodity prices, credit spreads, and foreign exchange rates suggest that Fed policy remains accommodative. So it’s unlikely that long-term rates moving into rough equilibrium with a still-easy Fed target rate will pose a restraint to growth.

Moreover, when these rates are viewed from the perspective of their real, inflation-adjusted levels, they hardly appear to present a threat worth mentioning. During the   economic boom of the later 1990s, real long-term rates averaged about 3.5 percent, and the economy didn’t begin to slow noticeably until they exceeded 4 percent during the Fed’s ill-conceived tightening campaign of 1999-2000. Today, the real (inflation-adjusted) 10-year rate is running at less than 3 percent.

This does not rule out the possibility that rates could yet reach a level where they would threaten growth. While the market has effectively unwound expectations for Fed rate cuts, there has yet to be a movement toward the recognition of the possibility that the Fed’s next move could be to hike rates. In due course, this is likely to come. The central bank has already given notice that it is becoming uneasy with the “resource constraints” represented by the unemployment rate remaining at a low 4.5 percent. In its archaic, demand-based model, such a tight labor market — with its attendant potential for wage gains — is ipso facto inflationary. The current reacceleration of growth is only likely to deepen those concerns.

At the same time, while recent readings from the official inflation indexes have appeared benign, the Fed’s long-standing easy-money posture at some point will likely show through in a renewed uptrend in core inflation.

When that happens, a course of sustained monetary tightening will be inevitable.


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