U.S. Bond Market Week In Review: Why The Fed Is About To Make A Mistake In Raising Rates

1.  What are the chances of a hard landing in China? The probability of a hard landing in China  is no higher today than it was earlier this year.
2.  Have U.S. financial market stress indicators worsened substantially?  Financial stress today  in the U.S. is not particularly high compared to the last five years.
3.  Has the U.S. labor market returned to normal? U.S. labor markets have largely normalized.
4.  What will the headline inflation rate be once the effects of the oil price shock dissipate? Oil  price stabilization likely implies headline inflation will return to 2 percent in the U.S.
5.  Will the U.S. dollar continue to gain value against rival currencies? Global policy divergence  has already been priced into foreign exchange valuations.  

Bullard’s analysis is somewhat superficial as there are strong rebuttals to several conclusions. Financial stress may be increasing for two interrelated reasons. First, as a result of Dodd-Frank, financial intermediaries are no longer inventorying corporate bonds, instead acting as brokers between buyers and sellers. This could be a problem if the market experiences a liquidity event. And the market may be closer to just that problem.CCC yields widened considerably over the last year, thanks to weakness in the oil sector.  Baa yields recently joined them:

The Moody’s Baa index is just shy of the peak of 5.58 per cent in August 2013 near the end of the “taper tantrum”, when yields rose sharply as investors anticipated that the Fed would start winding down its asset purchases.  

As for employment, if the sole metric used was the unemployment rate, one could argue the economy reached full employment. But broader measures of labor utilization such as U-6, labor force participation rate and people employed part-time for economic reasons still show high levels of slack, which weak wage growth confirms. Finally, Bullard argues oil is the primary reason for the drop in CPI.  But according to the latest IEA estimate, demand and supply won’t be in balance until 2020, implying weak oil prices for an extended period of time. 

But as Fed President Evans points out below, there is weakness over the entire commodities complex.

Chicago Fed President Evans offered a more nuanced outlook in his speech:

So what are these inflation risks? With prospects of slower growth in China and other emerging market economies, low energy and import prices could exert downward pressure on inflation longer than most anticipate. That’s a risk. In addition, while many survey-based measures of long-term inflation expectations have been relatively stable in recent years, we shouldn’t take them as confirmation that our 2 percent target is assured. In fact, some survey measures of inflation expectations have ticked down in the past year and a half. Furthermore, measures of inflation compensation derived from financial markets have moved quite low in recent months. These could reflect either lower expectations of inflation or a heightened concern over the nature of the economic conditions that will be associated with low inflation. Adding to my unease is anecdotal evidence: I talk to a wide range of business contacts, and virtually none of them are mentioning rising inflationary or cost pressures. No one is planning for higher inflation. My contacts just don’t expect it.

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Disclosure: None

Hale Stewart is a former bond broker who has been writing about economics and financial markets since 2006 on the Bonddad ...

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