The US Federal Reserve through its Chair Janet Yellen has been making clear in recent meetings and speeches that the “federal funds” overnight interest rate (close to zero) is going to be with us for a “considerable” period of time, possibly lasting until 2016, so long as unemployment stays above and inflation stays below the Fed’s targets of “full employment” around 94.5% and “core” inflation of around 2%. Just now both bond market professionals and the Fed know we are below each target by about 100 basis points (1/100th of a percent). But that’s where any agreement between them ends and where the bond market begins its latest quarrel with the Fed.
Bond traders always seem to think they know more than the Fed about money and the economy. Just listen to Rick Santelli on CNBC any day of the week: nothing new there. What’s new is the bond market seems to waver between two completely opposite assessments of why the Fed is wrong, both of which cannot be true: (1) that the economy is far weaker than the Fed gives it credit for (and is flirting with recession); and (2) that the economy is far stronger than the Fed realizes (and is flirting with inflation). Just now the first premise seems to be winning out, but the second always lurks under the surface. The combination makes bond prices a spurious guide to equity investors.
Yet commentator after commentator on CNBC and elsewhere keep warning the equity market that “the bond market is trying to tell us something” important. Rick Santelli went so far as to say that the bond rate “yield curve” is forecasting a new US recession. For a while, equity markets seemed to be intensely listening to its schizophrenic financial neighbor: every time the price of ten-year Treasury notes retreated (causing interest rate yields to fall) during the course of recent trading day, the equity market sold off very noticeably.
If the ten-year rallied and yields temporarily fell, equities would broadly rally in price also, even stopping for the moment the precipitous slide in the market value of so-called “momentum” growth companies in biotech and “new tech” areas like social and internet media, cloud computing, enhanced data security and even electric cars. These stocks had rapidly fallen out of favor with the onset of a rash of IPO’s and secondary offerings and insider sales in these sectors, with investors rotating away from them to so-called “value” stocks with far lower P/E ratios (and far lower earnings growth). This is in part under sway of the Fed’s bond market critics who argue that its Quantitative Easing (QE) programs have actually held back a more normal “return” to robust growth and that, as QE finally stops, the emerging strong economy will “lift all boats,” even heretofore growth laggards like Cisco and Intel. Why risk money on the high beta highfliers when you can get more from a quick pop from the “Dogs of NASDAQ” with less downside risk (since they are down so far already).
Sounds logical, but you have to buy both premises: that the economy will be coming back gangbusters, and that the likes of Cisco and Oracle can regain market share leadership from the newcomers like Salesforce.com and Workday and that have beaten them in the market during the tough years we have just come through. And you also have to disagree, of course, with the notion that the current bond market pricing is forecasting a recession, which would be a reason to get into cash, not a Cisco.
The Fed has announced both the tapered end of QE by the end of this fall and its intention to continue, however, with highly accommodative interest rate restraint until late 2015 at the earliest to give the economy the best chance to reach both its healthy employment and inflation targets by 2016. Bond traders seem to think both policies are wrong: that, on “free market’ principles, QE should already have been ended and that short term interest rates should be…here things get interesting….raised sooner rather than later because credit trading is not yet normalized but nonetheless should for now trade lower because the economy is actually in worse shape than the Fed realizes, at both the short end and the long end. Which makes for the classic ‘flattening of the yield curve” that often predicts recession! In short, bond traders seem to have seen Steve Martin’s “The Man With Two Brains” so often they have forgotten it was a comedy. And these are the folks the equity markets are supposed to pay attention to?
But could it possibly be that the Fed, not the bond market, that has its head straight? That the Fed realizes that the “weather deniers” in the bond pits are wrong to dismiss any relationship of the past winter’s excesses to December through February shortfalls in retail sales, construction activity and factory orders (all of which interim trends clearly have reversed in March according to actual data)? That the Fed realizes that a flight to Treasuries has been triggered far more by the crisis in Ukraine than by the bond trader mantra that the economic sky is falling in the US? That the Fed, moreover, has been able to pull off the tapered end of QE without the massive run-up in ten-year Treasury rates (that would have killed the slowly-emerging housing/mortgage recovery) feared last summer when QE tapering was first mooted by Chairman Bernanke. Indeed, money has flowed into Treasuries – perhaps more by happenstance (think Putin) than design, but better to be lucky than scared in most aspects of life.
In their defense, bond traders argue that QE has failed because interest rates actually went up during its heyday. But the Fed was not looking to drive down rates. It understood that longer term interest rates would rise with the economic recovery it was trying to stimulate by holding short-term interest rates down. It simply was using QE III to keep that increase within reasonable limits –-which even bond traders would have to agree it did.
Ever since the Great Recession hit, bond traders’ many apologists have criticized every single move the Fed has made, predicting both doom (rampant inflation) and gloom (a return to recession) – two phenomena that rarely, if ever, accompany each other! Perhaps the equity markets should indeed watch the bond markets carefully, not for ancient wisdom, but for signs of such inherent incoherence, and act accordingly. Maybe the Fed after all has the more correct and balanced view – that the economy is getting better, but needs more help to get really well, and the bond traders just need to get over it.
By Terry Connelly, Dean Emeritus, Ageno School of Business, Golden Gate University
Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.