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Why the Bond Market Trumps All

Irwin M. Stelzer

The bad news is that share prices have been plummeting, wiping billions in value off the holdings of investors and pension funds. The good news is that share prices are plummeting by thousands of points on the Dow, taking froth off markets and restoring monetary policy to its proper place in our economy. The good news is that the twin dragons of fear of Japanese-style disinflation and complacency have been slain. The bad news is that they have been replaced by new twin dragons: fear of inflation and panic. Those are the consensus views of economists.

Here’s the explanation. Start with the economy, which is in fine shape. It is growing at an annual rate of around 3 percent. The unemployment rate is at a low 4.1 percent, which is either at or within a hair’s breadth of full employment. Workers’ wages are finally starting to rise, after a long period of stagnation. Trump’s tax cuts have boosted corporate profits and take-home pay. Corporate profits are up by double digits over last year, 80 percent of S&P companies exceeded revenue expectations in the fourth quarter, and every executive I talk to expresses confidence that 2018 will be a good year—at times followed by a nervous laugh. Add to that happy picture a bit of context: Share prices have plummeted—but only to just about where they were a year ago and are still 20 percent higher than when Trump was elected.

The problem is not the economy, but the policy, stupid. For years the Federal Reserve Board has been operating on the theory that it can boost the growth rate of the sluggish economy by keeping interest rates close to zero. That would force investors to “search for yield,” to earn something on their money by taking on riskier investments, in this case stocks. That demand would drive up the price of shares and other assets, create a wealth effect, and boost the economy as the newly wealthier consumers trooped to the butcher, baker, and candlestick maker—as well as Hermés, Jimmy Choo, Cartier, and other purveyors of luxury goods.

Whether or not that strategy worked is the subject of some debate. We’ll know more when Janet Yellen, now ensconced at the Brookings Institution, produces the inevitable book and her critical reviewers have a go.

For now we know this: That the zero-to-low interest rate policy helped fuel the phenomenal rise of share prices that followed the election of Donald Trump, who rewarded Yellen by not renewing her appointment as chair of the Fed. As her last act, but not out of spite, Yellen did what one of her predecessors, William McChesney Martin, said central banks are supposed to do—“take away the punch bowl just as the party gets going.” And the stock market party was going full blast.

Almost coincident with a jobs report that showed the economy to be strong, and wages rising, the Fed perceptively announced that the economy is strong and wages are rising. Not surprising, but it led investors to wonder whether the Fed might raise interest rates four times this year, rather than the three times it has already pencilled in. Nervousness soon gave way to panic. Turning good news into bad, investors saw the tighter jobs market as an inflation harbinger, causing them to dump still more bonds, driving the interest rate up still further.

Then it became clear that fiscal policy was going from loose to looser. The tax cuts added about $1 trillion to national debt, even after accounting for their positive effect on growth. And Congress figured out how to end the partisan stalemate—give both parties money the government doesn’t have. Republicans got $165 billion for the military, Democrats got a $131 billion for their favorite entitlement programs. To raise that money (and the trillion to cover the tax cuts) the government will have to sell more bonds, probably twice the amount contemplated before the tax cuts and the budget deal, increasing the supply at a time when investors were already demanding higher interest rates to be persuaded to buy these IOUs. And just to make certain that the most sanguine of investors would graduate from concerned to panicked, Trump began talking about a $1 trillion to $1.5 trillion infrastructure program, financed by at least $200 billion of government borrowing (and probably more). Which drove bond price down and interest rates, which move inversely with bond prices, up further.

So what to do in this worst of all possible worlds: a Fed with its hands on the punch bowl, and a government that will have to sell huge amounts of bonds to inflation-wary customers. It’s one thing when there is little or no income to be earned holding bonds, but when 10-year Treasury bonds have a pay-off rate of 3 percent and higher, with little risk, some begin to wonder why hold onto high-priced shares. And sell.

But after an initial panic, not indefinitely. Sooner or later, fundamentals rear their lovely heads, and the growing economy and robust corporate earnings justify the newer, less frothy share prices that were dependent on a forever indulgent Fed holding rates down. All fine. Unless . . .

Unless the share price decline has a feedback loop into the real economy. A decline in the value of their investments spooks consumers into cutting back on spending, higher interest rates discourage corporations from going forward with some planned projects, and millennials decide to remain in their parents’ basements rather than enter the housing market. It’s called a recession, which I suppose Trump would call “treason.”

Presidents don’t take kindly to bond markets when their policies result in so much borrowing that what were once called “the bond vigilantes” saddle up, dump treasuries on the market, and drive up interest rates. Bob Woodward describes Bill Clinton’s reaction when told that his ideas for spending were constrained by rising debt, “Clinton’s face turned red with anger and disbelief. “You mean to tell me that the success of the program and my re-election hinges on the Federal Reserve and a bunch of ****** bond traders?’” When it became clear that the answer was “Yes, sir,” James Carville, a top advisor then as now, famously added this thought:

I used to think that if there was reincarnation, I wanted come back as the president or the pope or as .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.

On another note. Several readers pointed out that I erred last week by attributing the phrase “cock-eyed optimist” to Richard Rogers. Its creator was Oscar Hammerstein II, the lyricist of that partnership. Thanks for reading so carefully.

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