The Fed's Losing Control of the Financial Markets

In theory, market pricing reflects investor expectations about the future state of the economy. But in practice, it is hard to square a sub-2.60% yield on 10-year U.S. Treasuries — up less than a quarter of a percentage point over the past year — with the three Fed rate hikes in 2017, an economy that grew in excess of 3% in real gross domestic product terms in the second and third quarters of last year, and a labor market that is near full employment. Nor is it apparent that static long bond yields tally well with the robust pace of corporate earnings growth or household sector data.

The recently approved tax cuts will bring additional support for earnings in 2018, but they will also add to public borrowing even as the willingness of China and Japan to fund U.S. deficits to the same extent as in the past has come into question. Even after last week’s rise in longer-term yields, there are no signs that bond markets are pricing economic strength or geopolitical risk efficiently. A big part of market psychology has been the faith that the Fed will be inclined to repeatedly intervene in markets with more stimulus to hedge against financial volatility at the expense of controlling inflation.

To the extent that longer-term bond yields reflect the expected trajectory of real short-term rates plus inflation compensation and a term premium — the amount that investors would be prepared to accept to part with cash today — then the current flatness of the yield curve reflects a deeply negative term premium discount. This may be a legacy of the Fed’s massive balance sheet expansion via quantitative easing, but it is far removed from the current economic reality. 

As growth, jobs and now inflation return to more normal levels, expect the markets to follow. Since the U.S. 10-year discount rate provides the basis for an entire constellation of financial valuations, including stocks and credit, the implications will reverberate across assets and markets, well beyond the U.S.

Perhaps the catalyst for a change will be when inflation finally reaches the Fed’s 2% target. We’re not there yet, but a core CPI rate of 1.8% in December signals that U.S. inflation is alive and well, and the policy target is closer than investors may have assumed. But if the Fed is no longer in control of markets — or the path of inflation — the long road to squaring current financial euphoria with a more “normal” economic and policy reality may prove to be a bumpy ride.

— For more columns from Bloomberg View, visit http://www.bloomberg.com/view.