Bond and other capital markets have the ability to aggregate different views about the future financial prospects of firms and governments.
For instance, when inflation or the likelihood of default increases in an economy, lenders decrease their demand for an issuer’s existing debt, effectively punishing the debtor by driving up interest rates, making borrowing more costly.
Greek 10-year yields eclipsing 25 percent in 2012 during the country’s fiscal melee is just a recent example of such bond vigilantism.
Spending and taxation policies followed by the federal governments of advanced economies garner extensive attention by the public, policy makers and economists alike. A nation’s borrowing costs may depend on how financial market participants interpret the impacts of a wide range of factors, such as economic growth, expected inflation rates and federal debt levels, on the country’s ability to meet financial obligations.
U.S. 10-year Treasury securities, for instance, currently yield 1.99 percent, not far from the five-year low of 1.43 percent set in July 2012 and well below the post-1980 average of 6.3 percent. German, French and Italian 10-year yields stand at 0.38, 0.66 and 1.45 percent, respectively.
Bond markets are signaling, and have been for an extended period of time, that inflation is expected to remain anemic, wage growth will continue to stagnate and, ultimately, economic slack remains in the system.
The view of inadequate aggregate demand for goods
and services in our economy is further supported by the lack of upward price pressure across a variety of different metrics. To put the current state of inflation into historical context, the Bureau of Labor Statistics, in their most recent report on consumer prices, stated, “The CPI rose 0.8 percent in 2014 after a 1.5 percent increase in 2013. This is the second-smallest December-December increase in the last 50 years, trailing only the 0.1 percent increase in 2008.
“It is considerably lower than the 2.1 percent average annual increase over the last 10 years.”
Furthermore, the labor market establishment survey of firms reported that the year-over-year change in average hourly earnings for all employees for December was 1.86 percent. The post-2007 average, including the Great Recession period, is 2.32 percent.
Based on the efficient capacity of production, within which land, labor and capital would be fully employed, our economy is producing $378 billion below potential, or 2.3 percent.
Under-utilization in our economy can help explain why the unprecedented increases in the Federal Reserve’s balance sheet have not translated into inflationary pressures. We have been operating in a liquidity trap where short-term interest rates remain near the zero lower-bound and banks are awash in reserves above what they are required to hold with the Fed.
The Federal Reserve is expected to increase interbank overnight borrowing costs this year. And, while that may catalyze a ripple effect on medium and longer-term interest rates, bond investors ultimately determine these yields.
With monthly purchases of longer-term Treasury and mortgage-backed securities by the Fed behind us, bond markets have a new source of concern: the unwinding of more than $3 trillion in bond purchases.
Will the Fed simply sell the securities? How long will that take to unfold? Will the Fed increase interest rates on bank’s excess reserves so as to not flood the market with more funds chasing the same amount of goods? Will the Fed participate in reverse repos?
To top it all off, banks have also flocked to Treasury bonds since there exists a 100 basis point spread between five-year notes and the 25 basis points they could earn holding cash with the Fed.
How will interest rates change this year and what impact will that have on the economy and our nation’s fiscal position? A key component of that answer will depend on the views of bond market participants. Currently, the vigilantes appear at bay.
Nicholas J. Mangee is an assistant professor of economics at Armstrong State University and can be reached at Nicholas.mangee@armstrong.edu.
By Nichols J. Mangee