OPINION: What Is The US Bond Market Telling Us, If Anything?
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THE BridgeNews FORUM: A series of viewpoints
on an international market.
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* Demand For Inflation-Indexed Bonds Has Picked Up As Some Investors
Bet On Rising Inflation Ahead
By Scott E. Pardee of MIT's Sloan School of Management
CAMBRIDGE, Mass.--The recent backup in U.S. bond yields, with the 30- year "long" bond lately trading around 5.7 percent, reflects both supply and demand forces.
The U.S. economy continues to grow strongly, in excess of 4 percent. But both consumer demand and corporate capital spending are rising faster than gross domestic product, which means the private sector is not adding to savings and is relying heavily on credit to finance its purchases.
Certainly, consumers are spending more and saving less in response to the wealth effect from the rising stock market.
Investors are not moving huge volumes of funds into equities this
year, as measured by the rise in holdings in mutual funds. But the flow remains heavy enough to suggest that, on balance, they are still shifting assets from cash and bonds into stocks.
Thus the private demand for credit has increased, while the net supply of domestic funds to the bond markets has not increased and may even have decreased.
Foreign economies are not growing as fast as that of the United
States, leaving America with a record trade deficit, based on sluggish
exports and sharply rising imports.
Up to now, the United States has been able to finance its external
deficit by capital inflows. These inflows of foreign savings have
effectively offset the lack of savings here.
During the financial crises in Russia, Brazil and elsewhere in late 1998 and early 1999, American and foreign investors pulled money out of foreign markets and shifted into dollar instruments in search of a safe haven.
The sense of crisis has now passed, and investors are shifting some of those funds back into foreign markets. Even Brazil has been able to resume borrowing in international markets.
Fiscal policy in the United States is not yet a problem. The
Congressional Budget Office has forecast a surplus of $111 billion in the fiscal year that ends on Sept. 30. That is up from $70 billion last year.
Treasury officials have initiated discussions with dealers on how best to retire debt. That said, Congress is using the war in Yugoslavia to ramp up military spending.
Indeed, unless the president and the congressional leadership can get their acts together, we face the risk that Congress will pass pork, pork and more pork as the 2000 election approaches, easily cutting that budget surplus by as much as $50 billion.
Anyone trading and investing in U.S. bonds today has to be concerned that the surplus will be squandered.
Meanwhile, the bond market has been treated to a wonderful feast of new issues from high-quality corporate borrowers, with more than $200 billion of new borrowings since February.
Each of these bond issues has its own interesting story, as with
AT&T's borrowing to fund its strategic acquisitions and Goldman Sachs'
borrowing to capitalize on investor interest in the wake of its successful initial public offering.
But the fact that so many very savvy companies are coming to market now suggests they don't want to bet on lower interest rates later on.
Inflation remains benign, at around 1.5 percent, but is likely to get worse rather than better.
Oil prices are already up and should add a few tenths of a percent to the Producer Price and Consumer Price Indexes over the months ahead.
As Asia recovers and Latin America re-emerges from its own recent
crisis, the global demand for raw materials will expand sharply.
Meanwhile, Federal Reserve people are on a last round of speeches
before the May 18 meeting of the Federal Open Market Committee. A few of them are warning of possible inflation ahead, but they cannot make a compelling case for raising the federal funds rate now.
Nominal interest rates are not as important as real interest rates, net of inflation. Any measure of where the normal real interest rate should be is imprecise, whether 3 percent or 4 percent, but clearly the nearly one percentage point rise in the U.S. long bond over recent months is a rough approximation of the change in inflationary expectations.
The demand for U.S. Treasury inflation-indexed bonds has picked up
recently. These investors are already betting on higher inflation ahead. Thus, the balance of forces is negative, which shows through in chart patterns.
That is, if inflation remains benign and the U.S. economy cools
somewhat, the long-bond yield might level off or edge down to 5.25 percent or so.
But if something negative happens--for example, if the CPI rises by 0.3 percent per month for two or three months--then the long bond will go to 6 percent and higher, fast.
SCOTT E. PARDEE is a senior lecturer and executive director of the
finance research center at the Sloan School of Management, Massachusetts Institute of Technology. His views are not necessarily those of Bridge News, whose ventures include the Internet site www.bridge.com.
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