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The Horizon for Bonds Alan Reynolds and Jude Wanniski May 5, 1981 |
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Executive Summary: The long-awaited bond-market rally remains on the horizon although the Reagan economic program that was to have ignited the rally draws closer to successful enactment. Why? Conventional wisdom sees Treasury and corporate borrowing blocking the rally. But the logic and evidence supporting this argument are feeble. The record bond yields continue to reflect Federal Reserve policy driven by the inflation/unemployment trade-off, a fascination with high interest rates and slow growth as an antidote to inflation. But a slump will not help long bonds, as the market showed April 3 on the report of Fed policy. Only a shift to a price target, abandoning both fed funds and monetary aggregates, will produce an investment-grade bond rally. Thus far, hard-money advocates have been shut off from the government's policy-making councils, but the bond-market agonies invite new inquiries from the White House and Fed. A constructive tax bill will help bonds, improving the quality of all debt. Our six-month forecast on interest rates is a modest one, however.
The Horizon for Bonds
No single symptom expresses the U.S. economic predicament as does the unending agonies of the bond market. Those involved in putting together the Reagan economic package were acutely aware that sustainable progress is critically dependent on a major bond rally. The January 22 preliminary forecast had government bonds dropping to 10.2 percent by the fourth quarter, 7 percent by 1984. Even the published version of February 8, less optimistic on inflation, implied bond yields dropping to 8 percent by 1984. On April 27, David Stockman forecast that interest rates would fall to the "single digit range" in two years, if Congress passed President Reagan's tax and spending cuts. Unimpressed, investors marked down bond prices again. "Nobody wants to buy bonds yet," Ronald J. Talley of Pittsburgh's Mellon Bank told The Wall Street Journal. "There is a buyer's strike because investors don't like the outlook for inflation."
Why the delay in the long-awaited bond rally, especially with the outlook for the President's program so positive lately? The conventional bond-market wisdom seems to be this: Monetary and fiscal policies are on a collision course, with the Fed stubbornly refusing to finance the massive budget deficit. Corporations will also be heavy borrowers, needing billions from the credit market to finance inventories and investments; if bond yields dip, a surge of new issues will drive them back up. Thus, increased public and private borrowing combined with the Fed's tight money policies ensures that rates will stay high. A recession offers the only hope for lower interest rates, yet the economy remains suprisingly strong, indicating that interest rates must be kept high to slow the economy.
While this line of reasoning dominates the bond market, the evidence to support it is, for the most part, feeble:• The expected volume of Treasury borrowing this year and the next is not particularly large relative to the size of the economy. The deficit fell steadily from 4.5 percent of GNP in 1975 to 0.6 percent in 1979, yet the money supply, inflation and interest rates soared. High estimates of Treasury borrowing this year amount to about 2 percent of GNP, less than a third of what Japan routinely handles with enviable success.
Deficits certainly bear upon interest rates insofar as they are monetized or the market reckons they will be monetized. The quality of debt is all important. A debt to finance payments to individuals not to work (including unfunded pension-fund liabilities) suggests to the market that the government's ability to raise the resources via taxation 30 years hence will be diminished, and the government may be forced to monetize much of the debt in the year 2011. A debt to finance needed public works or incentive-oriented tax-rate reductions would cut in the other direction, implying a bigger economy in the year 2011, a relatively lighter debt burden to finance via taxation, less risk of monetiza tion, hence lower rates on bonds maturing in that year, sold in 1981. In this regard, the mounting multitrillion dollar Social Security liabilities dwarf the current Treasury borrowing in their impact on interest rates.
• Corporate credit needs are no more troublesome than the government's current needs. Henry Kaufman, Peter Bernstein, Donald Maude and others warn of big increases in business inventories and investments clashing with anemic profits and cash flow, requiring billions of external financing. How investment could be strong while profits were weak is left conveniently unexplained. There is no reason to expect that non-financial corporations will need any more external financing at all than last year, particularly since they're likely to get accelerated depreciation. Corporations are in the pits even deeper than governments, of course, because investors must reckon that in the year 2011, or whenever, the private sector will be picked clean by government taxation to finance debt at the same time all dollar assets are debauched by monetization.
• A more basic criticism of the whole flow-of-funds approach to interest rate forecasting is that it finesses the main questions of supply and price. It's not enough to simply add up all the loans everyone would like to have and then conclude that credit demands will force interest rates up. If interest rates go up, some of these hypothetical borrowers will never appear, and more funds will be supplied by domestic and foreign investors.
Table 1 shows that neither the total volume of funds raised nor the Treasury's borrowing alone tells us much about where interest rates are headed. Big increases in overall borrowing (including the Treasury's) were associated with lower interest rates in 1971 and 1976-77; declines in borrowing in 1973-74 and 1979-80 were associated with rising interest rates. Heavy borrowing in itself does not cause high interest rates or inflation. The credit process is potentially inflationary only when financed with new money — when there are more dollars borrowed than saved, or when the market is forced to discount the likelihood of that happening in the future. That's where Federal Reserve policy is critical.
TABLE 1: FUNDS RAISED BY NONFINANCIAL SECTORSTreasury
Funds Raised Prime Borrowing
(percent change) Rate (billions)
1971 45% 6.3% $22
1972 25 5.8 17
1973 21 8.3 6
1974 -8 11.3 12
1975 -30 8.7 69
1976 62 7.5 53
1977 39 7.8 46
1978 23 9.8 29
1979 3 13.2 15
1980 -20 15.2 62• Another common worry is that corporations will lengthen their debt, offering so many new bonds that a glutted market must keep yields high. The paradox should be obvious: Corporations will supposedly borrow long because the interest rate falls, yet the rate can't fall because corporations are borrowing.
Table 2 shows that large new issues (last May through July) were accompanied by the lowest yields, and vice versa. Corporations will raise nearly $40 billion in the bond market this year only if bonds rally, and the $40 billion would not abort the rally because it is quite small relative to outstandings, and less than a tenth of the funds raised each year in credit markets.TABLE 2: BOND SUPPLY AND YIELDS
New Corporate Bonds AAA
(billions) Yield
1980
Jan: $2.8 11.7%
Feb. 1.4 13.2
Mar. 1.8 14.1
Apr. 2.7 13.4
May 6.2 11.6
June 7.3 11.1
July 5.4 11.5
Aug. 2.9 12.3
Sept. 1.8 12.7
Oct. 2.3 13.2
Nov. 1.0 14.1
Dec. 1.6 14.4
1981
Jan. 2.7 14.0
Feb. 2.1 14.6
Mar. 3.2 14.4
• A drop in interest rates need not weaken the dollar, because inflows of foreign capital ultimately depend on real rates, after inflation. High nominal interest rates have long been a classic symptom of weak currency countries. High real interest rates, on the other hand, can only persist if the funds can be put to productive uses that yield a good return. A good real return on bonds, after taxes, will both reflect and facilitate the financing of profitable opportunities.A SLUMP WON'T HELP
Federal Reserve officials at times appear to embrace the dismal trade-off of recession to lower inflation and interest rates, and the idea is deeply embedded in Fed policy. More than anything else, this single idea stands in the way of the long-awaited rally in bonds that the Reagan administration knows must accompany its growth strategy if it is to succeed. The idea is also popular among Keynesian wage-push theorists and the so-called "monetarist" advisers to Margaret Thatcher. It isn't as popular among investors in the bond market. The April 3 disclosure that the Fed intended to keep the fed funds rate above 15 percent seemed to trigger a renewed collapse of bond values. The commitment to a high nominal fed funds rate indicates that the Federal Reserve still equates "tight money" with high interest rates rather than with slow growth of its own portfolio. In fact, the only way that the Fed could keep rates above 15 percent for long would be to finance a comparable rate of inflation. With rapid increases in the monetary base, inflation would keep credit demands strong enough to keep banks bidding for fed funds at rates above 15 percent. With a genuinely tight policy, on the other hand, interest rates must fall with declining inflation.
One side of the Fed's balance sheet is, of course, the monetary base (currency and bank reserves), which supports the whole pyramid of money and credit, however defined. Table 3 shows what accelerations and decelerations of the base do to bond yields. Clearly rapid expansion of the base (at a 9 percent rate over the last two months) drives interest rates up, not down. This is particularly true of long-term rates, which are critical. People do not build factories or buy houses with 30-day credit.TABLE 3: FED POLICY AND BOND YIELDS
Monetary AAA
Base Bond Yield
(annual rate) (basic points)
Dec. '79 - Mar. '80 8.0% 222
Mar.-June 6.1 -238
June-Nov. 11.5 239
Nov. '80- Jan. '81 -0.4 -20
Jan.-Apr. 7.0e +95e
e = estimate
The mechanisms built to effect Fed policy, though, are designed around the idea that the way to slow the growth of money is to crunch the real economy. People and firms will then be too impoverished to obtain credit and the Fed won't feel obliged to pump up bank reserves to legalize all increases in loans and deposits. In February 1980, after a year of stagnation and with the economy poised on the brink of collapse, Fed Governor Nancy Teeters told Barron's, "What would bother me most would be if we had resumptions of very high rates of real growth."
To slow the real economy in order to slow the growth of the money supply involves a classic perversion of priorities (as does trying to balance the budget by letting inflation raise tax rates). Slow growth of money is not an end in itself but one means toward preserving the quality of money. Indeed, as that objective is consistently pursued, people will become more willing to hold larger cash balances so that a measured rise in the money supply need not imply inflation at all. In fact, we should expect a bond rally to be accompanied by a rise in the M quantities of money, reflecting the increased willingness to hold dollar balances.
The Fed's model, though, remains driven by its Phillips Curve inflation/unemployment tradeoff, and thereby prevents the above from taking place. Reserves are added to the banking system when real growth is slow; reserves are withdrawn when real growth is considered "excessive." Thus, money poured into the economy in the slump ensures that spending will outrun limited production, creating inflation. When the real volume of production and transactions begins to rise, though, Fed policy works to deliberately stifle the increase in credit needed to finance inventories, durables and housing. By alternating between financing excess spending when production is weak, and periodically choking off spurts of real activity, Fed policy contributes to chronic stagflation.
Throughout April, the Fed overreacted to weekly money wiggles caused by a spurt in Social Security payments, the tax date, expected changes in Treasury balances, and the added reserves required when people shift money from pass book to NOW accounts. Toward the end of the month the Fed pulled billions of reserves out of the system, leaving banks scrambling for fed funds at rates up to 24% in a week when the money supply was falling.
If monetary policy were conducted to achieve almost any price target rather than to influence the real economy, Fed authorities could begin to restore confidence in the durable value of the dollar. The Fed could measure its performance by a single price (the dollar/gold ratio), an index of commodity prices, growth of national GNP, a long-term interest or exchange-rate trend. Targeting the price of gold is likely to produce the most durable dollar value because it is historically the best proxy for all prices, the prices of current production (goods and services) and the prices of future production (represented by financial assets). The fall in the price of gold and the strengthening of the dollar in the last several months is no reason to applaud Paul Volcker & Co., however. It is simply a by-product of the Fed's continued targeting of short-term interest rates (really the overnight fed funds rate) at austerity levels. If the market knew the Fed were targeting the price of gold, ignoring the Phillips Curve shiftings of aggregates or the direction of short rates, its confidence in the long-term value of the dollar would expand and the bond rally would be underway in a big way. The exchange economy, no longer glutted with money in slumps or starved for liquidity when straining for real expansion, would have every reason to fuel a further bull market in stocks as well.
The supply of central bank money (Federal Reserve credit or base) would presumably rise more slowly under a price rule than it has over most of the past decade, but how much more slowly cannot be known in advance. If the value of a dollar became the specific objective of policy, people would become more willing to hold a larger share of their income and wealth in convenient monetary forms. Time and resources now devoted to conducting the most transactions with the least cash could be employed more productively. Most importantly, a rate of growth of transactions money (M1B) that would be considered inflationary in today's setting would become far less so because velocity would slow. The supply and demand for money would then come into balance with fairly stable prices because the demand for money rose in pace with supply.* * * * *
For the bond market to get out of the doldrums, something has to change in the way monetary policy is conducted. This implies a change in people. A shift in the policymaking framework, from a consumer/demand framework to a producer/supply framework, is so fundamental that it is extremely difficult to see how change would be effected simply by applying outside pressure to the current team. The Reagan administration has so far closed off this option. Counseled by Arthur F. Burns, it has instead kept up a constant praise of Fed independence. The reason he could sell this idea is that none of the White House high command understand the issues, and are probably grateful to be free of responsibility on having to grapple with monetary policy.
Where the solution, for them, would be to delegate this responsibility to the best advocates of the varied positions, letting the clash of ideas work at policymaking, the influence of the Old Guard has also been effective. Arthur Laffer was offered no role in the administration, and his heretical views on money remain safely penned up in his classroom in Southern California. Lewis Lehrman of the Lehrman Institute and Eugene Birnbaum of the Securities Group, the two leading supply-side monetarists in the financial community, were both sealed off from the Reagan administration. Supply-siders have been given powerful seats in shaping fiscal policy. But incredibly, with the President a hard-money advocate and the GOP platform of 1980 vowing a return to a monetary standard, not a single advocate of these ideas has been given a chair at any of the tables that shape monetary policy.
The appointment of monetarist Jerry Jordan to the Council of Economic Advisers filled the last such chair, to the dismay of the supply-siders. Along with Treasury's Beryl Sprinkel, Jordan is likely to push for gradual slowing of the Monetary base — the right instrument, but not the right target. This is an improvement on targeting a sky-high fed funds rate, but does not broaden the policymaking debate beyond quantity theory and the monetarist demand model.
The other council member, William Niskanen, remains an enigma to the press. A specialist in how to tame bureaucracy, Niskanen invariably favors rules and institutional disciplines over any non-system that gives politicians and officials vast discretionary authority. Most relevant, but not well known, Niskanen has deplored the loss of monetary discipline from ending the gold standard and fixed exchange rates. Not a pure hard money man, Niskanen is at least sympathetic.
Bob Dederick, on the other hand, is as pure a Keynesian as can still be found. Although Commerce has not been an important policy slot, his office as chief economist can be a source of monthly misinformation in the interpretation of economic data.
Among the Fed Governors, Gramley and Partee are most pernicious, with Teeters not sufficiently knowledgeable to be as serious a threat. There's not much chance of replacing any of them soon, but Vice Chairman Shultz will be replaced in 1982. Governor Rice is not that fond of the job, and could probably be induced to take a position in the private sector. Otherwise, internal change at the Fed will have to come from the regional bank presidents (several critical posts are changing hands) and the research staff.
Paul Volcker himself is sympathetic, the way Niskanen is, but he is essentially a bureaucratic product of the Fed-Treasury network and finds it difficult to understand the clash of concepts and theories that swirl about monetary policy. He is thus incapable of being the point man to effect fundamental change. It would not occur to Volcker to replace old friends within the research staff who supply the" Fed with consistently bad advice. If the top Fed researchers take private jobs (and there has been some interviewing), the news would bode well for bonds, unless the positions were filled from within the incestuous establishment.
The Fed research staff has mastered every conceivable excuse and uncovered every plausible scapegoat for many years of unqualified monetary mismanagement. They violently resist change, particularly any reduction of the discretionary authority to find tune on a daily basis, letting New York's rusty computer respond to a hundred or so inconsistent signals. And they are allied with New York Federal Reserve President Anthony Solomon, the most important single supporter of the "floating dollar" in the bureaucracy, reflecting the view of his constituency, the money-center banks. Solomon's recent proposal that the weekly money-supply figures not be disclosed reflects the bunker mentality among the monetary authorities. Solomon must suspect, deep down, that he hasn't the foggiest idea of what he's doing, because nothing works. The only alternative explanation lies with scapegoats. For Solomon, the money manipulations are correct. It's the public that reacts incorrectly to the news of the manipulations. Shut down the reports. To Beryl Sprinkel, whose job as Undersecretary of Treasury for Monetary Affairs gives him influence and responsibility over the dollar exchange-rate and no influence over domestic monetary policy, the problem is domestic money manipulation. Sprinkel thus pushes through Treasury the new policy of not supporting the dollar (leaving Sprinkel without any identifiable responsibilities except peddling Treasury debt). For Fed Governor Henry Wallich, a key player throughout the last dozen years of monetary chaos, the problem is President Reagan's tax cuts.
Last November, the vice chairman of the Board of Governors, Frederick Shultz, echoed the Fed's tune that markets are inherently volatile and that Fed policy is simply a great stabilizing force. "More stable provision of reserves by the System," said Shultz, "would mean heightened interest rate volatility." In reality, the supply of reserves has become far more volatile than ever before, with interest rates reacting to each monetary surprise. The Fed has not stabilized reserves at the price of stable interest rates; the Fed has systematically destabilized both the quantity and price of credit.
Oddly, where Sprinkel and many of the pure monetarists now support the Reagan tax program as a means of encouraging output and a bigger tax base, traditionalists like Henry Kaufman continue to complain that the President's plan would "place nearly all the anti-inflation effort squarely on monetary policy." Yet when the Carter administration emphasized Kaufman-style fiscal policies to combat inflation (budget balance and price guidelines) financial values collapsed. Now, if expected inflation will "remain high because the financing requirements of the government will remain high," as Kaufman predicts, then why did inflation not decline from 1976 to 1979? Kaufman is rightly concerned about high household debt and anemic profits, but this is a curious reason to oppose tax relief. He seems to argue that economies are better run on credit than on internally generated funds.INVESTMENT IMPLICATIONS
Otto Eckstein of Data Resources says "No serious business would plan its future on the basis of such optimism" as is included in the administration's forecast. That forecast shows five years of real growth averaging about 4.5 percent a year — exactly the same as the last expansion, and weaker than any other except 1955-56. It takes four years to bring inflation down as quickly as we did in a year or two last time. After almost no real growth since the first quarter of 1979 and a forecast of a recession in mid-'81, the recovery bounces back at only a 5 percent rate — compared with a postwar average of 6.9 percent in the first year of the recovery.
It is more prudent to make plans on the basis of fashionable pessimism, cynicism and skepticism? Not if that means opportunities are missed. The retailer who runs out of inventory is not more clever than* his optimistic rival. The investor who remains in short-term securities is not necessarily wiser than the one who moves into stocks and bonds before their prices go up.
There is upside potential as well as down, and things have not changed so much that we can safely rule out a replay of 1976. At that time, real GNP rose by 5.4 percent, the comparable measure of inflation fell from 9.3 percent to 5.2 percent, real business fixed investment rose by 5.3 percent (despite less than 80 percent of manufacturing capacity being utilized), the DOW ended up 48 percent higher than in early 1975, the fed funds rate dropped more than 800 basis points from the mid-1974 peak, and unit labor costs slowed from 16-17 percent increases to 3-4 percent within two years. All of this happened with a deficit of 4.5 percent of GNP (fiscal 1976), and 6 percent growth of M1B. Now, it is supposedly impossible with a deficit half that size and even faster money growth.
By mid-April, the adjusted monetary base was running at a 7.5 percent annual rate over the previous year. If continued, that is more than enough to finance a 10-11 percent growth of nominal GNP, the short-term division between real growth and inflation being largely influenced by tax policy. A mix of 6-7 percent inflation and 4-5 percent real growth is surely not beyond reach, and would mark an encouraging first step toward a truly healthy performance (such as 5 percent real growth and 2 percent inflation). The predictable explosion of equity values would facilitate financing of business expansion, increase household wealth and confidence, and draw funds from tax shelters and hedges.
The markets already tell us what the consensus forecast is. The trick is to be at the margin of new information that may move the markets, including knowing when they moved for the wrong reasons. The long run is more than a series of short runs, and a shift in market perceptions about the long-run outlook can shift markets very quickly. Some view of the future and what can change it remains essential to strategies and commitments.
For such reasons, bonds are probably a more interesting vehicle for the near-term than stocks, i.e., for speculation. Current bond yields more than compensate for any plausible inflation risk, and even modestly good news on the monetary and inflation front is likely to generate some hefty gains. For the long-run, for investment rather than speculative trading, bonds must await the changes in people and policies that bring systematic guarantees of sound money. There have been vague stirrings in this direction. In recent weeks there have been renewed, extended discussions between Volcker and the supply-side monetarists, at his request, simply to discuss theory. There have been similar meetings with the White House high command. The only question remaining is whether it will take a monetary crisis before the White House demands answers from those who it expects a bond rally from, leading to resignations and policy changes. Or, does the President's known tastes for hard money suggest policy changes and fresh people can be brought into play prior to crisis. The sickening plunge in bond prices in the closing days of April suggests time is running out on the latter solution and that it may take a crisis — a wave of bankruptcies — for the President to openly question monetary policy in a way that produces fundamental change to the supply side. Short of such a crisis, it's doubtful the White House will be able to shift its attention to money away from its fiscal program.
The stock market already incorporates a decidedly hopeful attitude toward tax policy, since every cut in marginal tax rates has raised the DOW by 15-30 per cent in the first year alone. By late April, the market had probably discounted the best part of the President's three-year tax proposal, which was really diluted into a four-year plan. Indeed, the President's popularity and his pep talk to Congress on April 28 may have had perverse effects on the market, if it means Democrats will more likely support the phased-in tax cuts. In recent weeks, Democrats and Dixie-crats have been seriously advancing "compromise" tax bills that included steep cuts in the top personal tax brackets (the Brodhead amendment), a 70 percent exclusion on capital .gains, and substantial reform of gift and estate tax progressions. In other words, potential "compromise" legislation might easily be better for the economy and the stock market than the President's standing proposal.
There is no necessary trade-off between stocks and bonds. Total returns, for example, rose for both stocks and bonds in the recovery of 1970-72, as well as in 1975-76. The bull market in bonds has been on the horizon for several months, but the change in policy that would ignite it has remained just as elusive. Our expectation, though, is that with a modest decline in the rate of inflation, no increase in external funds needed, and the lengthening of corporate debt to strengthen balance sheets, demand for short-term financing should ease substantially by summer. The yield curve should then shift toward normal, with both short and long-term market rates in the 10-12 percent range by late fall (mortgages and the prime slightly higher). But should there be a revived hard-money outlook from the Oval Office between now and then, our expectations would not be so modest.* * * * *