Yesterday’s dramatic bond market crash may make some people worry about rising rates, but I disagree. First, this year has seen an unusual degree of tax cut stimulus with huge federal deficits. This stimulus acted to make economic statistics including employment, hotter than normal, which resulted in rising interest rates. However, the typical scenario of a big stimulus package is a 5.5% GDP growth, not the 3.2% for the first half of 2018. The fact that the economy is growing 2% slower than it should (based on tax cuts) implies the stimulus may soon fade away and thus reduce the risk of inflation.
During the two days before the monthly BLS Payroll Employment report bond yields tend to go up as traders worry they could be surprised by a surge in employment. Thus some part of the recent rate increase could be an incorrect signal from the market. A more balanced test of the bond market is the closing price on the day the Employment report is released, which is Friday, Oct. 5.  Since the bond market will have a holiday on October 8, then a better sampling of data would be the closing price of bonds on Tuesday, October 9.
Assuming there is a labor boom and that employers have to get into a bidding war to hire workers then they will seek to use small business subcontractors. Typically smaller business act as a reserve labor force for the top 500 big companies. Thus small business companies encounter more risk of economic fluctuations, since they may find when the economy has slack during a soft period that the giant companies can hoard consumer demand for goods and services, to the detriment of small companies. The advantage of using a small company as a subcontractor is that wages can be higher in the little company because the workers in the big company can’t use that as a reason to demand a raise. Then when the recession comes those high paying jobs evaporate, thus lowering average wages.
Big corporations dominant need and policy is to cut costs (mainly labor) through globalization. The rest of the Developed world has many financial problems and high youth unemployment, except in Japan. Couldn’t some work duties be sent to the EU (where youth unemployment in Italy is 33%) or some of the unemployed EU workers could move to Canada and work for a U.S. company to meet demand for labor?
As a metaphor, if bonds were a person on trial in court, in order to convict bonds of the crime of having an excessively low yield, the prosecution would need to demonstrate that all the extremely bad disinflationary financial conditions (negative interest rates, huge debts, huge unemployment, lack of demand for goods and services) in the EU, Japan and the UK will somehow magically go away and their interest rates will return to normal. There is no sign of improvement for the EU, only a rising risk of bad news in Italy and the UK with Brexit. There is too much risk that Japan’s recovery is unreliable because they had so much debt, devaluation, central bank buying of stocks using newly printed money, and negative interest rates, thus they are unlikely to participate a global inflationary employment boom. The hypothetical court case would fall apart.
Yes, I understand that bond investors don’t want to invest in another country because of devaluation risk and the high cost of currency hedging. But the point is that global weakness will leak into the U.S. acting to tamp down our inflation. At some point foreigners will get so frustrated with their low yields they will break their own safety guidelines and make an unhedged lunge for U.S. bonds. Imagine a German getting a negative 0.5% yield moving into U.S. 2 year Treasury Notes yielding 2.87%, some 3.37% higher – that’s a huge reward that some people can’t resist. This yield is tax free for foreign non-resident investors, so that’s like a 5% taxable equivalent yield for them. Assuming the EU and Japanese investors alternate best hope is to buy a telecom stock yielding 5% then they would be just as well off buying a U.S. Treasury. I remember when the ECB made an aggressive push to negative rates in January, 2015 this made U.S. bond yields go down so that complacent bond managers were hurt because the change triggered a payoff, at par, of premium priced bonds, causing a 2% loss of principal. This was allowed to happen because domestic bond managers assumed that the EU’s problems couldn’t spread to U.S. markets. There is a real possibility that U.S. companies will continue their push to move jobs offshore where they pay about 12% to 14% tax versus about 25% in the U.S. (including state income tax).
Wages are up 4.2% for restaurant workers and 4.0% for retail workers, but those tend to be shaky, undesirable jobs with volatile work hours and volatile income where demand is high at the top of a cycle for those industries. But then in a recession when demand crashes these jobs are lost. Some of these workers, on an inflation-adjusted basis, had a huge pay cut over the past decade, so it hardly seems inflationary if they are merely getting back to par. The unreliable nature of those jobs means workers are less able to access bank credit which means less chance of an inflation-causing increase from bank lending to retail and dining workers.
Today Fang index was down 3% and the SP down 0.87%, copper was down 2%, oil down 2.6%. This is disinflationary.
Investors need independent financial advice about the risks of misunderstand bonds and inflation.