The pullback in stocks the past two trading days is both long overdue and healthful. But after nearly a decade of easy money engineered by the Fed and other central banks, is the sell-off in the bond market simply a short-term tantrum? Or is it the start of a secular bear market in bonds, due to higher inflation, that can only end in tears?
If one thinks about interest rates as simply the price of money, one could argue that the correction in stock prices would be more worrisome if accompanied by significantly lower bond yields than higher ones. In that regard, higher rates suggest that the economy is no longer so fragile as to require the “extraordinary monetary accommodation” that has kept the federal-funds rate lower than inflation since June 2008.
With the consumer price index running at only 2.1%, higher rates appear to indicate that investors expect a stronger economy and corporate profits rather than impending inflation. The historically modest current increase in the cost of money tends to validate the rally in stock prices since President Trump was elected.
While we all naturally tend to view our most recent experience as typical, the low interest rates some of us have enjoyed since the financial crisis have been anything but normal. They are atypical of a healthy economy that allocates capital properly. Even odder than the low level of interest rates since the “expansion” started in 2009 has been their invariability. Historically, the yield on a 10-year Treasury note has been roughly equivalent to the level of nominal growth in gross domestic product (real growth plus inflation). That would imply that the rates should have averaged 3.4% since 2009 and should be roughly 5% today. Instead they have averaged only 2.45% and are now 2.71%. Why?
The academic economists who have been setting monetary policy would see this as heresy, but there may be a sense in which the best intentions of the Federal Reserve to save the world from the financial crisis at some point started to impede economic progress rather than foster it. More troubling, there is evidence that the Fed’s policy mix of easy money and tight financial regulation disproportionately benefited wealthy people with financial assets while hurting poor and middle-class people who earn interest on their savings.
