Soaring Bond Yields May Be Short-Lived
The Federal Reserve doesn't readily concede errors in judgment. That's why Chair Janet Yellen’s statement on Sept. 26 that the central bank misjudged inflation was particularly significant. The speech was an important factor in the subsequent rise in U.S. Treasury yields.
Bond yields were further boosted by the tax reform package unveiled by President Donald Trump on Sept. 27 that includes fewer brackets and lower rates for individuals. Estate taxes would end. Corporate profits would be taxed at lower rates and new incentives would be provided for business investments.
Yet this double whammy on the bond market may not have lasting power. The Fed's intentions and the proposed tax cuts are unlikely to start a trend toward higher inflation and faster growth that would impose losses on the holders of Treasuries and prompt a shift toward equities.
The surge in bond yields is a déja vu moment. I said in an article in February that Treasuries were cheap at the then-prevailing yield on 10-year obligations of 2.32 percent. Low inflation and slow growth would not support a much higher yield. The yield hit a low of 2.04 percent earlier this month and, even now, is around its late-February level (chart below) despite the recent developments.
It is important to ask why recent history may repeat itself in the weeks and months to follow. There is a low probability that the Fed and the Trump administration would be able to successfully implement their policies. And if the measures do not cause inflation growth to accelerate, bond markets are likely to push yields down once again.
Start with the Fed. Its preferred inflation measure is the personal consumption expenditure deflator. Even as the central bank worries that the falloff in inflation may be transitory, this inflation index, excluding food and energy, has not met the target level of 2 percent even once since the first quarter of 2012. Missing the target for more than five years in a row is no transitory phenomenon.
Worsening the Fed’s quandary, inflation has fallen further below target in the first two quarters of 2017 (chart below). Rather than wait until sufficient research is done to determine the cause of a falling rate, the decision appears to have been made to assume that inflation would rise, and to march ahead with tightening policy.
This would suggest that the Fed may no longer be “data-dependent,” as it has repeatedly indicated, but rather calendar-dependent, determined to keep hiking, regardless of the data. There is a history of the central bank acting in this manner.
After deciding not to implement a widely anticipated rate increase in September 2015, the first hike since the financial crisis occurred in December even though nothing much had changed during the intervening three months. The Fed had repeatedly promised it would tighten policy before the end of the year, and did so.
The calendar dependence is likely to cause the Fed to increase rates even if the economy is not strong enough to tolerate them. Such a move would end up lowering longer-term Treasury yields.
Consider the prospects for tax reform. In the short term, the priority will be not on taxes but on increasing the debt limit beyond December, when it expires. In implementing growth-oriented tax cuts next year, the administration would still have to identify limits on other deductions to pay for the trillions of dollars of revenue losses.
Some of the tax-cut measures and the revenue-enhancing offsets that are being considered face intense opposition in Congress.
In the case of tax reductions, consider the elimination of the estate tax, which applies only to the wealthiest Americans. It is likely to face opposition because it would reduce revenues but bring no benefit to the majority of the electorate.
The outlook for passage of measures could be even worse in enhancing revenues. In particular, expect opposition even from Republicans in high-tax states such as California, New York and New Jersey to the proposed limitation on the state and local tax deduction, known as SALT. An administration that could not get a health-care bill passed despite a Republican majority in the Senate may face a similar situation with its proposal for SALT.
Message for investors: Do not give up on Treasuries and high-grade fixed-income instruments. In a slowing economy lacking inflationary pressures, they are still likely to provide attractive returns.
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