Janet Yellen and the Fed think they now have a confident view of where the U.S. economy is going and are preparing for a hike in short-term interest rates later this month. With short-term interest rates so low, a mere 25 basis point hike is hardly a major event.
But the question is whether the Fed is missing the fact that the financial markets are sending conflicting signals. On the one hand, the stock market is signaling that the economy is about to take off like a rocket. On the other hand, the long bond market is signaling that the economy is still likely to experience subpar growth. Put another way, given the impressive performance of the U.S. stock market since the November election, 10-year Treasury yields should be much, much higher.
But they are not. True, yields bumped up some last week after the Fed Chair said a rate hike this month is virtually certain-but only back to their levels of a month ago.
Note that Mrs. Yellen says she will likely raise short-term interest rates largely because 1) the U.S. stock market is booming and consumer sentiment is rapidly improving; and 2) the international financial situation has improved. By “improved” she means that producer prices (the PPI) globally are no longer collapsing. Disinflationary pressure is subsiding throughout emerging markets and even in Europe. But is this slight pickup in the PPI globally due mostly to massive Chinese speculative buying in the commodities markets (after the government took steps to curb real estate speculation)? The Chinese market is so big that massive commodities speculation can affect prices worldwide. What happens if the Chinese government, as it did with over-speculation in real estate, steps in with measures to curtail commodities speculation to avoid a commodities bubble?
The wild card is whether tax reform becomes a reality in 2017. The stock market says tax reform is a slam dunk. The long bond market is signaling that the promise of a 3-4 percent economy for 2018 is hardly a certainty if Congress remains in stalemate.
David M. Smick is a macroeconomic adviser to a select group of prominent global investment funds and a non-fiction author. He is the chairman and CEO of Johnson Smick International, a financial advisory firm in Washington, D.C. where he is in partnership with former Federal Reserve Vice Chairman Manuel H. Johnson Smick wrote an acclaimed book The World Is Curved on the financial perils of globalization, in response to The World Is Flat bestseller by Thomas Friedman.
