Where in the World are the Bond Vigilantes?

Investors and speculators have sometimes acted to impose financial discipline when they have concluded that officials are being too lax. The economist Ed Yardeni coined the name “bond vigilantes” to describe such participants when they are doing this. With the third year of a strong global expansion, rising commodity prices and nearly every country reporting rising price pressures, global bond yields remain low. Although numerous central banks have raised interest rates in recent months, credit expansion remains robust and the global economy still seems awash in liquidity. Moreover, in the midst of this global expansion, the major industrialized countries continue to run large budget deficits.

Where in the world are Yardeni’s bond vigilantes?

The answer given by many observers over the past couple of weeks, and especially in recent days, is that there is no need for them in the US. New Federal Reserve chief Ben Benanke, who was vilified in the spring, is now embraced, if not as a Jedi-Master, at least a Padawan--a Jedi in training. Perhaps, though a better image is a ronin--a samurai without a master.

The thrust of Bernake’s argument since ascending to the pinnacle of the Federal Reserve is that the moderation of the economy will dampen price pressures. It is a deceptively simple claim. There was no doubt that the economy was moderating. The 5.6% US growth recorded in Q1 was an outlier and partly was distorted by the hurricane-induced weakness at the end of 2005, when in Q4 the economy expanded at a paltry 1.8%. In addition, the market well appreciates the weakness in the real estate market, which previously had played such a key role in fueling the expansion in terms of employment and consumption.

Rather the problem lied with the inflation part of the Chairman’s claim…until this week. Starting in March and running through June, core consumer prices had risen at a 0.3% rate each month. The market learned in recent days that the rate moderated to “only” 0.2% in July. This followed on the heels of a soft wholesale price report, in which core prices fell 0.3% in July. The market had expected a 0.2% increase. Maybe, the market concluded, Bernanke knows what he is doing after all.

Growth Under-Estimated

Just as the criticism of Bernanke in April was probably misplaced, so too is the recent triumphalism exaggerated. Turning first to the growth side of the argument, the resilience of the US economy is not fully appreciated and this speaks more to the fear among investors more than real economic weakness per se. As Dallas Fed President Richard Fisher noted Q2 GDP is likely to be revised higher. The new estimate will be released on August 30 and Bloomberg consensus calls for a 3.1% pace, which would put it back close to where economists estimate is trend growth and is still a sufficient pace to absorb slack in the economy.

The contraction in the housing market appears to be still accelerating. However, the link between US housing market and consumption might be exaggerated. July retail sales rose an impressive 1.4%, the largest rise since January. Even excluding the incentive-led auto sales, the US consumer did not stay at home, but instead increased purchases by 1%. Retail sales account for nearly half of US personal consumption expenditures (PCE). The July PCE will be released on August 31. The year-over-year rate has been in a range between 5.4% and 7.6% since the Fed began raising interest rates in mid-2004. At 6.2% in June, in is just below the midpoint of the range. Although the year-over-year pace is likely to have moderated further in July, as last July’s 1.3% increase drops out of the measure, there is little sign that the US consumer is in true retrenchment mode.

The August Philly Fed index was also well above market expectations and, when coupled with the Empire State survey, it points to a rise in the national ISM report from the 54.7 reading in July. Although the July leading economic indicator index slipped 0.1%, the Conference Board, which compiles the data cautions against ideas that it is pointing to a contraction in the economy. By its reckoning, the LEI would need to contract by 3.5% at an annualized pace over a six month period to signal a recession. In the six months through July it has declined at less than half that pace. The last time this took place was in Sept 2000, six months before the beginning of the recession.

Inflation has not Peaked

Just as the market may be exaggerating the economic weakness, it also seems to be too easily dismissing price pressures. It is true that the pace of wholesale inflation moderated in July, but there is little correlation between this measure and consumer prices and the Fed’s favorite measure, the deflator on personal consumption expenditures. Core consumer prices still accelerated in July to a new cyclical high of 2.7%.

Core PCE prices rose 0.6% in Q2, 0.7% in Q1 and 0.6% in Q4 05. The year-over-year rate of 2.4% matches the high since September 2002, which is also the highest reading since 1995. The 3 and 6 month moving averages, which Bernanke has cited in the past, continue to accelerate.

Moreover, the base-effect warns that further increases are likely in the months ahead. Recall that in the second half of last year, there were three monthly reading of lowly 0.1%, including in July and Aug, which will drop out of the year-over-year comparisons.

The Federal Reserve has acknowledged it also looks at inflation survey data. The preliminary August University of Michigan survey is consistent with this argument that price risks are still to the upside. The one-year inflation expectations rose to 4.2% from 3.2%. This is the highest since October 2005. Given that the price of gasoline is easing, it would not be surprising to see a lower print when the final report is released, but it seems fairly clear that inflation expectations provide little comfort.

The economist Henry Kaufman, called Dr. Doom in the 1970s and 1980s for his sobering outlooks, wrote a provocative op-ed piece in the Wall Street Journal on 14 August. Among other things, he noted that credit expansion has not only continued since the Fed began raising interest rates, but the pace has accelerated. Debt in the US of non-financial institutions grew by a 10% pace last year, which he compares to 6% pace in 2001. Outstanding credit derivatives have increased from $4 trillion at the end of 2003 to an estimated $17 trillion at the end of 2005.

Part of Kaufman’s argument is that the financial engineering has allowed economic actors—households, businesses, investors, and speculators to resist or minimize the efforts of US monetary officials to moderate the credit cycle through higher interest rates. Kaufman, for example, notes that typically profits from financial disintermediation (banks) get squeezed when the yield curve flattens, but not this time. He argues that financial institutions are successfully overcoming the “retarding” impact of Fed policy and have actually increased the volume of outstanding assets, liabilities, off-balance sheet commitment and profits. Asset backed securities and collateralized debt obligations help do for businesses what adjustment rate mortgages or variable payment schemes do for the household-reduce the impact of the Fed’s efforts.

James Carville of “it’s the economy stupid” fame once quipped that when he is reincarnated he wanted to come back as the bond market, because then you can intimidate every one. But that was when the bond vigilantes were the driving force. Now the bond vigilantes have been de-clawed. Carville might want to reconsider his choice. Yet before eulogizing the bond vigilantes, if the argument here is close to the mark, that the US economy is more resilient than the 2.5% preliminary estimate of Q2 GDP would suggest and that price pressures are also more virulent , the reappearance of the bond vigilantes might be the new new thing.