Having It Both Ways on the Bond Market’s Message

Posted September 3, 2010 at 2:54pm

My Aug. 3 column about the former “bond market vigilantes” now being obvious federal budget deficit cheerleaders generated a great deal of attention and lots of pro and con comments.

[IMGCAP(1)]The biggest complaint by far was that the bond market will someday change its mind, think that the economy warrants lower rather than higher federal deficits and start to push up interest rates in anticipation of that not happening. We should deal with that, the complainers said, by beginning to reduce the deficit immediately.

The best way to demonstrate the absurdity of this position is to ask what the complainers would be recommending if the mirror image of this situation existed. What would they say, for example, if the bond market were signaling that deficit reductions were called for as unequivocally as it is now demanding more stimulative policies?

Would the same people who responded that we should ignore what Wall Street is saying and start to reduce the deficit in the face of low economic growth be just as adamant that, if the bond market were back in a vigilante mode, we should begin to adopt policies that increase federal spending, reduce taxes and raise Washington’s borrowing because, after all, at some point it will change its mind?

Of course they wouldn’t.

If it was important to hear what the bond market vigilantes were saying in the 1990s — and it was — it’s just as vital to listen to what the bond market deficit cheerleaders are saying today.

There’s no doubt that the bond market will turn on a dime — or in this case on a few hundred billion dollars — when economic growth is projected to be at the levels where traders are worried about federal budget policies leading to shortages of raw materials, goods and labor and, therefore, inflation. That’s what markets almost always do when they get and understand new information: They change.

But the likelihood that Wall Street will be concerned about an overheating economy at some point down the line doesn’t detract from the message that it is unambiguously sending now: Given unemployment and capacity utilization (among other measurements), slow growth and deflation rather than excessive growth and inflation are the primary concerns.

Because of that, federal deficits and additional stimulus are not feared or fearsome. Not only is there no reason to begin to reduce the deficit now, the bond market is saying there are strong reasons to do just the opposite.

Some of those who disagreed with the Aug. 3 column said that given the usual lag between when a change in the economy occurs, the change is recognized by policymakers and the legislative process is able to deal with the new information, budget policies have to be adjusted before the bond market calls a new play. (Forgive me, but after all, football season is under way.)

But that ignores the role of the Federal Reserve, which has the ability to change monetary policy long before Congress and the White House usually are able to revise existing fiscal policies and well in advance of when deficit reductions take effect. And because in this case the Fed would be raising interest rates to deal with a perceived threat of overheating the economy, its ability to move decisively and by whatever amounts are needed would be far greater than its current options, which are limited.

The question asked at the end of the Aug. 3 column — Why aren’t the bond market deficit cheerleaders being heard or followed by policymakers? — continues to be the most interesting, but in light of some of the responses that I received, it needs to be asked differently: Why is it seemingly so easy to dismiss what the bond market is saying today when what it said before was taken as gospel and as if it was handed down from on high?

Some of the reasons I offered a month ago continue to be realistic and very plausible. The lower interests that the bond market is using to send its message today simply aren’t as potent a threat as the higher rates that it was imposing almost 20 years ago. As a result, the politics of lower interest rates just isn’t the same and the imperative for dealing with them quickly is very different.

In addition, given the financial services sector’s overall low approval ratings and the fact that Federal Reserve Chairman Ben Bernanke is much less willing to comment forcefully on fiscal policy issues than Alan Greenspan was, it may simply be easier for legislators today to give short shrift to what the bond market is saying.

But given how easy it is to demonstrate that those who refuse to listen to what the bond market is saying are trying to have it both ways — it’s important to listen to Wall Street when it says deficit reductions are necessary, but it can be ignored when it says the opposite — it’s hard not to conclude that the primary reason the bond market doesn’t have the influence it had before is that it is saying something very different from what many want to hear. Because of that, they have to reinterpret what the market is saying so that even though the message being sent actually is completely different, it somehow means the same thing.

Stan Collender is a partner at Qorvis Communications and founder of the blog Capital Gains and Games. He is also the author of “The Guide to the Federal Budget.”