Bond investors, your time is up. Four consecutive months of weaker-than-expected inflation excited buyers, helping them rationalize the unrealistic heights reached in the bond market even though the underlying economic fundamentals are simply inconsistent with prevailing interest rates. That’s something the Federal Reserve fully appreciates, but investors don’t.
Many people, including Fed Chair Janet Yellen, have been surprised by the recent slight moderation in inflation. It’s inconsistent with any known economic theory, and almost impossible to rationalize. But this also means it could reverse just as quickly without explanation. It could simply be an outlier and we are simply returning to more normal behavior.
Start with the labor market, because it broadly crosses all industries, all population groups, all regions, and every part of the economy. Any objective reading of the data indicates that labor is scarce. More growth might only squeeze out some incremental supply, but not enough to undermine that conclusion. Job openings are at record highs. Layoffs are at record lows. Job growth remains above labor-supply growth, so the scarcity will only worsen.
The economic background is very favorable for continued growth. Labor scarcity may force companies to increase capital investment to enable firms to substitute capital for jobs. Since corporate profits are doing well, businesses can afford such investment outlays. Spending will only help reinforce the expansion and the demand for labor.
The Trump administration would love to reduce taxes, increase spending on infrastructure, and reduce regulation. Dysfunction in Washington has prevented much of substance from making its way through the approval process, at least so far. But it is unrealistic to think that absolutely nothing will happen. And any progress implies a more stimulative fiscal policy that will spur growth.
Globally, central bankers have been pulling out all the stops to promote healthier economic recoveries, notably in Europe and Japan. The European Central Bank is preparing the market for a tapering of its quantitative easing monetary policies as growth firms. Japan is also performing better. The U.K. will soon be raising interest rates. A global economic expansion tends to be mutually reinforcing, as healthier growth in Europe implies more demand for imports from the U.S. At the same time, solid growth in the U.S. implies stronger demand for imports from those regions. This will also make it harder to disrupt.
Returning to the U.S., there is no economic theory that suggests it is realistic to expect inflation to moderate when unemployment falls to historic levels. The bond bulls, however, either deny the labor market is tight, which requires a highly selective or strange reading of the data, or simply suggest this time is different. For a sense of when tight labor markets will finally spark faster inflation, economists rely on averages of historical experiences, even though each one may be different. And this one may be different, too, in that it may simply take a bit longer this time. (See my commentary on Sept. 11 describing one factor that explains why it’s taking inflation so long to accelerate even though the labor market is tight.)
The recent period of slow inflation has enabled the Fed to keep rates on a gradual upward trajectory, and they should continue on that path lest they be forced by the market to move more sharply later with potentially damaging results.
Bond yields are unsustainably low. At the recent 2.05 percent, 10-year Treasury notes provide negative after-tax and inflation returns locked in for a decade. That’s hardly a satisfactory investment. With monetary policy still highly accommodative, thus promoting faster growth at a time when resources are already tight, something will give and it will be higher inflation — even if we don’t know precisely when that will happen.
Investors should be protecting the capital value of their bond portfolios by shortening duration as much as they can, even though that’s painful because of the associated decline in interest income. Higher yields are available on longer maturities, but at the cost of much greater risk. A 1 percentage point rise in yield on a note maturing in two years would only lower its value by 2 percent, but the same increase would lower the value of a 10-year note by 7.8 percent and a 30-year bond by about 19 percent.
One could lose six years of interest income on a 30-year bond from a 1 percentage point rise in its yield. In truth, there is a bubble in the U.S. bond market. Rather than rationalizing prevailing rates, investors should be fleeing, even if we can’t pinpoint when the bubble will burst. Investors who chased tech stocks in 1998 and 1999 came to regret that decision. This time, it will happen in “safe” U.S. Treasuries, much as it happened in the government bond market in the 1950s. Forewarned is forearmed.