“Taper” is certainly the buzzword of the month for May, and the associated rise in yields spanned a full 62 basis points. Though the 165K increase in April Payrolls reported on May 3 was an upside surprise that kicked off the month, the catalyst of the historic move was more so three words Bernanke uttered while speaking on Capitol Hill. A Senator asked if the Fed would begin tapering as soon as Labor Day, and Bernanke answered: “I don’t know.”
The selloff in bonds is overdone. In particular, over the coming months I expect yields will collapse, towards 1%.
There is a reason yields are not there now. The fundamentals and long-term economics suggest that eventually the Fed will engineer inflation, eventually financial repression will end, eventually there will be a painful Fed exit, and the process of getting to eventually will involve an overshoot of rising bond yields. However, for present purposes, the “eventual” is almost entirely irrelevant, as the road to eventually is paved by current economic conditions, market technicals, and monetary policy dynamics. The route to higher rates will be circuitous.
The problem is that as inflation falls further below its target, and the economy continues to slow, Bernanke, and his presumed successor Yellen, will engineer dramatically lower 10-Year yields, putting the Fed balance sheet, and tapering concerns, on a distant back burner.
We have been living in a “New Normal” world: 1) It has been hard to achieve a high growth surge that normally follows a slow-down; 2) bucket loads of fiscal and monetary stimulus have left the globe even more levered than in 2007; and 3) there is now a risk of a hangover, meaning that current slow growth could descend into deflation and an implosion of asset values. We may find ourselves in second financial crisis, involving sovereigns and currencies, worse than the first involving real estate and banks.
Though post-2008 the plumbing problems have been patched, we have neither launched into a meaningful post crisis growth rebound, nor built up meaningful capital and net worth. Capital building, in a narrow sector like U.S. homebuilders, in bailed-out firms like AIG, FNMA, and General Motors or in the banking system more generally, has occurred simultaneous with increases in the public debt, and Central Bank balance sheet in the U.S., Europe, Japan, and elsewhere, each of unprecedented proportion. Meanwhile central bank capital, the net worth that assures that a central bank’s assets exceed its liability to currency holders and depositors, cannot sustain any meaningful losses on their asset side.
Turning to the household, gains through 2013 have been very concentrated. Even though pre-2008 market index peaks have been breached, average household net worth, adjusted for inflation is languishing (see graph). Researchers at the St Louis Fed put it this way: “Considering the uneven recovery of wealth across households, a conclusion that the financial damage of the crisis and recession largely has been repaired is not justified.”