Wednesday, July 16, 2014

Bond Yields Don’t Rise When The Fed Tightens Prematurely

  • Many pundits are predicting stronger growth and higher bond yields.
  • They are misreading the monetary data.
  • The FOMC is withdrawing stimulus in the face of slowing growth.
  • The outlook is for low money growth, low inflation, low nominal growth and low bond yields.
  • This is bullish for both stocks and bonds.

There is a growing chorus among the economic pundits that the economy is picking up steam, that monetary policy should “normalize”, and that bond yields “will have to normalize”. This consensus is not supported by the data.
Nominal growth, inflation and bond yields are artifacts of monetary policy. Monetary policy today is restrictive and becoming more so. If the quantity equation holds, then we won’t be seeing any pickup in nominal growth that could justify higher bond yields. Anyone who thinks that the first quarter growth numbers were caused by “winter” isn’t looking at current monetary policy. (This may come as a shock to Al Gore, but the government still seasonally adjusts the quarterly GDP data.)
The bottom line for the economic outlook is that the Fed is withdrawing stimulus in the face of falling growth. This is not a monetarist Fed; it is a hawkish Fed. While the FOMC is not as Austrian* as the ECB, the Austrian hawks on the FOMC have an effective veto over any policies intended to stimulate inflation and nominal growth--due to the institutional priority placed on consensus and “credibility”.
Despite the fact that both Bernanke and Yellen are dovish monetarists, the policy mix that we are seeing today and can expect to see in the future is Austrian Lite, which is a compromise between monetarism and Austrianism. We are going to get a continuation of low inflation, low nominal growth, and low bond yields. We will not see again the high levels of nominal and real growth that we saw during the Greenspan years. That is, not unless there is a radical change in the composition of the FOMC.
There is nothing to stop the Fed from raising the funds rate, since this is within its complete control. But the impact of a rate hike in a weak economy is deflation and lower bond yields. A higher funds rate will not raise bond yields; it will just flatten the curve and create a recession.
What is the policy stance of the FOMC today? Judging by its actions, as opposed to its palaver, the policy stance is to target an inflation rate below 2%, to grow the money supply in the mid-single digits, and to tolerate abysmal levels of nominal and real growth. In other words, Austrianism Lite. The policy is restrictive; the brakes are on. This is not monetarism.
Bush and Obama appointed dovish monetarists to the chairmanship, hoping for good growth and low unemployment. But the minute a dovish academic walks into the Eccles Building, he stops being an economist and becomes a consensus-seeking, controversy-avoiding "manager". The monetarists are institutionally captured, no matter what they truly believe about economics. The real job of the Fed chair is institutional credibility and continuity, not growth or other humanitarian desiderata. The last thing that a Fed chairman wants to be called is "controversial". This is analogous to the job of the chief justice: retain credibility and respect.
The post-crash FOMC has not completely ignored its full employment mandate, but mainly pays it lip service. It’s slogan (like that of the ECB and the pre-Abe BoJ) is “We’re doing all that we can do and monetary policy is not a panacea”. They are “creating the conditions” for recovery, but take no responsibility for making it actually happen. They are defying the quantity equation. I can only wish that Milton Friedman were still around to be able to explain to Bernanke and Yellen that the pace of nominal growth is within the control of the Fed. Friedman did not put the quantity equation on his license plate because he didn’t believe in it.
So today we have 6% money growth, falling velocity and dangerously low nominal growth. In the face of that data, the Fed has decided to end its balance sheet expansion. The FOMC has declared victory and now plans to do nothing further.  So why in the world should we expect nominal growth and bond yields rise in such circumstances?  Let’s look at what the bond market thinks: 10-year yields have fallen from 3.0% to 2.6% this year. That does not suggest that the bond market expects a pickup in nominal growth let alone higher yields. Why would falling bond yields lead people to expect higher bond yields? Why would falling growth lead people to expect accelerating growth? It’s as if the data didn’t exist.
Investment Conclusion
We are living in a “new era” of slow money growth, low inflation, low nominal growth and low bond yields. Since low bond yields support high stock PE multiples, this news is bullish for both stocks and bonds, but stocks will continue to outperform bonds (because the equity premium is so high).
*Austrianism is the belief that the optimal policy of the monetary authority is price stability, rather than moderate nominal growth or full employment. (Paul Ryan, Rand Paul and Paul Gigot are Austrians.) Austrians reject the quantity equation (money growth = nominal growth) as simplistic and meaningless. They believe that if the central bank delivers price stability, the economy will grow at its “natural” pace and that growth should not be stimulated with "monetary steroids". They believe that recessions naturally occur and naturally correct without fiscal or monetary stimulus, and they recommend supply-side measures such as regulatory reform and lower taxes. This philosophy (once espoused by Herbert Hoover and his gang) has created 12% unemployment in the Eurozone, a shrinking nominal economy in Japan for two decades, and U6 unemployment in the US of 12% five years after the Crash.

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