Stephen King: Bond slump shows fragility of US recovery

Before I went away, I wrote about the US "soft spot", the economic weakness seen in the middle of the year that seemingly caught everyone by surprise. Coming back from holiday, it seems to me that the soft spot has, if anything, got even softer. Demand remains rather depressed in the US but the problems are no longer confined to President Bush and Alan Greenspan. Japan's industrial performance has begun to disappoint after impressive gains earlier in the year. The UK's long-awaited housing price slippage may finally be under way. And the eurozone never really offered much economic excitement in the first place.

The obvious explanation for this increasingly "synchronised" weakness lies with higher oil prices. Countries have hit a brick wall because they simply cannot cope with oil prices above $40 per barrel. On its own, though, this explanation doesn't seem convincing. Most econometric models suggest that the immediate impact of higher oil prices tends to be relatively small. The problems come when the increase in oil prices leads to a "wage-price spiral" that, in turn, forces aggressive monetary tightening from central banks. Long-term interest rates then rise rapidly, drivenby tighter monetary policy and rising inflationary expectations.

Yet this simply has not happened. Monetary tightening may have had some effect in the UK, particularly when combined with the persistent warnings from the Bank of England about the potential over-valuation of the housing market. Elsewhere, though, these effects have not transpired.

The US provides the best example. It is certainly true that, earlier this year, fears of higher inflation began to reappear. Many felt that the Federal Reserve's decision to begin tightening monetary policy reflected this fear. A few months later, though, and inflation appears to be remarkably quiescent. In the three months to July, core consumer price inflation - excluding food and energy components - rose just 1.8 per cent year-on-year and by only 1.6 per cent on a three-month annualised basis. In other words, underlying inflationary pressures are now trending down, not up.

Nor is there any evidence that the strength of oil prices is leading to a pick-up in wages. Headline inflation remains relatively high - 3.0 per cent year-on-year - because of higher energy prices but the labour market remains weak: August's 144,000 gain in payrolls was a lot lower than is typical of economic recoveries, when gains of between 200,000 and 400,000 are usually seen. Against this backdrop, it is difficult to see where the impetus for higher wages is going to come from. These observations may help to explain a genuine financial markets peculiarity, which will either prove to be a moment of summer madness or will show that the world is evolving in unexpected ways.

The peculiarity is the performance of bond markets. When was the last time that US 10-year Treasury yields fell against a background of rising oil prices? When was the last time that 10-year Treasury yields fell at the beginning of an apparently prolonged period of monetary tightening? Why is it that investors are buying bonds - pushing up their prices and, hence, lowering their yields - when most economic fundamentals should be telling them to sell? Tighter monetary policy, higher oil prices: in normal circumstances, these alone would be enough to drive bond yields significantly higher. Yet the right-hand chart shows all too clearly that, as short-term interest rates have risen, long-term rates have come down.

This decline in long-term rates raises other difficult questions. Periods of monetary tightening are typically unhelpful for equities, but one of the more obvious reasons for poor equity performance is the rise in the discount rate - the bond yield - applied to future earnings growth. This time, though, the bond yield has come down, suggesting that other factors must have contributed to the poor performance of equities this year.

Janet Henry, at HSBC, has looked at all the occasions when Fed tightening has been followed by a sizeable decline in bond yields. There are less than a handful of occasions, and, if there is a common thread - bearing in mind the sample size is small - it is that these periods that signal the end of monetary tightening. In other words, the next move in official interest rates is usually downwards.

It is difficult to believe that we are in this situation now. Could American monetary tightening really be over? Most unlikely, I would say. The Fed has laid its cards on the table, wanting to bring official interest rates back up to a level consistent with "neutrality". Most economists would regard neutral interest rates to be in line with the trend rate of growth of nominal GDP (in other words, if output rises at 3 per cent a year and inflation averages 2 per cent a year - a long term steady-state situation - "neutral" short-term interest rates should be about 5 per cent).

The problem with this return to "neutrality", though, is the misbehaviour of the bond market. Most Americans tend to borrow at long-term interest rates, not short-term rates, so if long rates fall when short rates rise, it isdifficult to argue that monetary policy has been tightened at all. Doubtless there are distortions to the US bond market. Heavy Asian central bank buying has probably had some impact, as Asian central banks have intervened in the foreign exchange markets to prevent their currencies from rising against the dollar. But I am not sure this is the complete explanation. I wonder whether, in three or four years, we will look back at 2004 and say: "Ah, yes, that's the year when monetary policy was tightened prematurely, when the recovery really wasn't in the bag at all." The decline in bond yields is unusual. If it is telling us that nominal growth is going to be lower than we have been used to, it may imply that monetary tightening this year will simply have to be reversed next year.

"Neutrality" is a fairly strange concept. Economies are not predestined to grow at certain rates. If there has been a major misallocation of resources, there is a good chance that economies will veer away from the previously accepted "neutral" growth rate for quite some time. Asset bubbles are a prime cause of such resource misallocations. They lead to too much demand in the short-term and too little demand later on. Could the bond market be telling us that we have just been through one of these periods of resource misallocation? If it is, we cannot be in a standard cyclical recovery. And, if that's the case, we should not expect a standard cyclical monetary response.

The Fed has frequently argued that Japan's macroeconomic problem in the 1990s reflected a failure to cut interest rates quickly enough when the equity bubble burst at the beginning of that decade. Maybe, though, Japan's macroeconomic problem was more of a failure to limit the scale of the bubble that inflated in the late 1980s. If so, the US and Japan have more in common than most commentators would care to admit and we had better get used to a world of fragile and short-lived recoveries. Perhaps the US bond market is already there.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com