Conflicting Signals
Following a very tepid start, it now appears as though the Federal Reserve has embarked, in earnest, on its first tightening cycle since 2004-2006. During the previous cycle, the central bank raised the Fed Funds rate a total of 17 times, in increments of 0.25%, before finally reaching a peak of 5.25% in 2006. This time around, the Fed is clearly taking a more cautious approach having increased the Fed Funds rate just 4 times in 18 months. The caution this time around reflects relatively low and uneven economic growth as well as subdued levels of inflation. But there is one similarity between then and now that is worth pointing out.
Well into the tightening cycle in 2005, the Fed could not understand why long-term interest rates had not risen in response to significant increases in the Fed Funds rate. Even after the Fed Funds rate reached 4% from a starting point of 1%, the yield on the 10-year Treasury bond still hadn't budged much. Fed Chairman Alan Greenspan repeatedly referred to the behavior of long-term interest rates as a "conundrum" before finally settling on a "global savings glut" as the source of unusually strong demand for Treasury bonds (and therefore stubbornly low long-term interest rates).
Fast forward to 2017, and we could be seeing the same pattern develop. Despite ongoing assurances from the Federal Reserve that economic growth is set to accelerate and inflation to rise toward its target of 2%, long-term bond yields fell precipitously beginning in mid-March. The yield on the 10-year Treasury bond plummeted from a high of about 2.63% in mid-March to a low of 2.13% in mid-June. Since that time bond yields have rebounded somewhat, but they remain meaningfully lower from those first-quarter highs.
Under normal circumstances, bond yields would be expected to rise against the backdrop of accelerating economic growth, rising inflation, and a Fed intent on removing policy accommodation. Higher economic growth would be expected to raise the demand for loans, and therefore the cost to borrow, while rising inflation would further increase nominal interest rates. As well, we would expect bond prices to fall (and yields to rise) with the Fed signaling further interest-rate hikes and plans to begin selling assets from its $4.5 trillion bond portfolio. So what gives? Why aren't long-term rates increasing to reflect these developments?
One of two things is happening, in our opinion. The first possibility is that the markets are concerned about a policy mistake by the Fed. Under this scenario, the economy is not on a path toward acceleration beyond the 2% pace of the last 8 years. As a result, investors are unconvinced that the Fed will follow through with its plans to remove policy accommodation. The second possibility is that the bond market is wrong and the Fed is correct. Under this scenario, economic growth is indeed set to accelerate, and therefore the threat of higher inflation must be addressed through the removal of policy accommodation.
In the first scenario, there is a solid case to be made that the Fed, armed with recent data, will actually slow or halt interest-rate increases going forward. There are already individual members of the Fed that have made public their view that inflation is not high enough to justify methodical interest-rate increases. And indeed, as we look at the numbers, it's hard not to sympathize with those dissenting voices. Wage growth remains stubbornly low even as the unemployment rate has dropped to 4.4%. Year-over-year growth in average hourly earnings has decelerated to 2.5% from the high of 2.9% in December, 2016. This has confounded the Fed as it calls into question one of its most basic economic tenets, which says that falling unemployment will lead to higher inflation.
Other inflation indicators are telling the same story. Growth in the Consumer Price Index (excluding Food & Energy) has dropped precipitously over the past several months from over 2.3% to just 1.7% in May. Similarly, the Fed's preferred measure of consumer inflation, the Personal Consumption Expenditures deflator, has also dropped for four straight months to just 1.4% in May. Chair Yellen contends that transitory factors such as the drop in oil prices and falling prices for mobile phone contracts are causing the near-term deceleration. Is she right?
If Chair Yellen is not right, the stakes are quite high. Interest-rate hikes could have dramatic implications for an economy that has only produced an average of just 2% growth during eight years of near-zero interest rates. A policy mistake that isn't caught in time could risk thrusting a still-fragile and debt-ridden economy into recession. So, the drop in longer-term Treasury yields could be signaling an increased likelihood of a Fed-induced recession.
The second (and less likely) possibility could be that the bond market just has it wrong. It could be that the Fed has managed its exit perfectly so far, neither underestimating inflationary pressures nor creating financial-market dislocations with negative ramifications. As I write, the bond market continues a sell-off that began on June 26 and has seen the yield on the 10-year Treasury rise to 2.37%. Is this increase in interest rates representative of a capitulation by bond investors? Is it likely that 1) the Fed is smarter than the collective wisdom of the bond market; and 2) the Fed has designed a near-flawless reversal from an unprecedented monetary experiment?
For our part, we think the Fed could indeed be in the early stages of making a policy mistake. Ideally, the Fed should have begun the process of removing policy accommodation several years ago. The emergency measures taken were no longer necessary once the immediate threat of the financial crisis passed. As things currently stand, though, the Fed will likely soon recognize that in the absence of aggressive fiscal stimulus from Congress (the odds of which are decreasing each day), the economy is not strong enough to withstand sizeable increases in interest rates. At that time, the Fed will likely pause and reevaluate. Unfortunately, simply deferring interest-rate hikes (again!) may not have the benign and soothing impact on the markets as in times past.