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August 09, 2011

The Bond Market Verdict: It’s the Weak Economy, Not the Budget Deficit

Andrew Fieldhouse

Over the past two weeks, the stock market has undergone an abrupt correction, with the S&P 500 dropping 16.8% between closing on July 22 and yesterday’s close. It appears that investors are wising up to the fundamental weakness of the economy, paired with the rapidly escalating Eurozone debt crisis. Both the slide in stock prices and the rush to the safety of U.S. Treasury debt, which lowers yields (interest rates), are telling the same story: investors are worried about the faltering economic recovery, not the U.S. budget deficit.

Yesterday, investors shrugged off Standard & Poor’s credit rating downgrade and raced for the safety of Treasuries, sending yields on 2-year notes to record lows. Unlike Europe, which faces a very real debt crisis, the U.S. debt ceiling crisis was artificially concocted, and historically low interest rates across a range of Treasuries securities reaffirm the faith in our credit and ability to service our debts. A closer look at Treasury yields confirms that investors’ concern is the fundamental weakness of the economy, not the deficit.

The yield on 5-year Treasury notes (reflecting both near- and medium-term budget and economic concerns) is near record lows, 67% below its average yield over the last decade (see chart). Investors are demanding a lower return on Treasuries than any time during the 2008 financial crisis, and are so risk averse that they are accepting rates of return that fall shy of inflation. Treasury also issues Treasury Inflation-Protected Securities (TIPS), which adjust the bond principal for inflation (interest payments on this principal correspondingly fluctuate with inflation). Investors are willing to accept a negative return on these inflation-protected securities and have been for much of 2011. These historically low interest rates reflect dimming prospects for the recovery and indicate that government borrowing is not crowding-out any private sector investment. Indeed, a temporarily large budget deficit is beneficial for the depressed U.S. economy because it cushions the implosion of the housing market, weak consumer demand, and underutilization of productive resources.  

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Finally, if the bond market were predominantly worried about the short-term U.S. budget deficit and accumulation of debt, inflation expectations would be rising (government crowding-out would be generating inflationary pressures). But inflation expectations remain below the 2% rate that the Federal Reserve believes to be roughly consistent with promoting both price stability and full employment. The difference between nominal Treasury yields and TIPS yields shows roughly the rate of return investors are willing to forgo in exchange for inflation protection (this is the grey shaded area in the chart). Inflation expectations rose earlier in the year, following commodity prices, but that trend has reversed itself on weakened prospects for growth. (This yield spread is an imperfect proxy because the nominal Treasuries market is a larger, more fluid market than the TIPS market.) Domestic inflation remains subdued because of high unemployment and meager wage growth—again this is a story of economic weakness, not crowding out or economic overheating. The Federal Reserve just confirmed that inflation is expected at or below optimal levels, committed to maintaining exceptionally low short-term interest rates (0% - 0.25%) for another two years, and is discussing new policy tools. At present, fiscal policy is a better remedy for weak demand and Congress should be discussing new policy tools as well.

Why are markets suddenly more concerned with the economy? For starters, we recently learned that the economic downturn was 24% deeper than previously assumed and the recovery has been weaker, with meager annualized growth of 0.8% in the first half of the year. The last three employment reports have been dismal, with employment growth averaging only 72,000 a month. The economy has created only 1.9 million jobs since employment troughed in early 2010, with another 11.1 million needed to return the unemployment rate pre-recession levels. Finally, the debt ceiling deal all but guarantees an end to the last remaining stimulus polices – the payroll tax cut and emergency unemployment benefits – and instead initiates contractionary spending cuts. Relative to current budget policies, this pivot will reduce employment by roughly 1.8 million jobs in 2012. (New concerns about the viability of the European Monetary Union are also weighing on markets, but we don’t have direct policy levers for that problem.)

Investors are stimulus junkies — and we’re now seeing stimulus withdrawal. Policies boosting growth and consumption are good for investment opportunities and corporate profits. Without the federal government to deliberately boost investment and consumption, investors are uncertain of the source of near-term growth. Odds of a double-dip recession are up (50-50 according to Martin Feldstein) and markets are down. Like the recent GDP numbers, the slide in stock prices and Treasury yields reinforce that fiscal policy should prioritize a sustainable recovery instead of caving to deficit hysteria and complacency about feeble growth and high unemployment. The debt ceiling deal vastly complicated the task of strengthening economic growth, but we still have the policy levers to do so—we just need the political will.

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