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Who's Afraid Of Which Wolf?
On the first Friday of each month, the Labor Department releases payroll, wage, and unemployment statistics for the prior month. So far this year, on five of seven "first Fridays," surprise strength in the report has shattered the financial markets.
In their efforts to explain why good news has caused so much pain, the news media have had a harder time with market psychology than Tigger had with the tablecloth.
The New York Times and wire services have insisted all year long that the bond market fears the Fed, which may raise its rates in response to a hot job market. Economists employed by brokerage houses would have you believe the stock market dominates the bond market. Commentators on the left see it all as wicked conspiracy: those terrible capitalist pigs make money from downsizing, and job growth spoils their fun and profit.
Wolves everywhere and nowhere. Who is afraid of the big, bad whom?
Here is the authentic food chain: the real wolf is inflation, the worst of which is unleashed by a too-tight labor market and excessive wage growth. Inflation frightens the bond market, which in turn terrifies the stock market.
An investor in bonds buys the right to a fixed future stream of income. Inflation reduces the value of that income in two ways: the income has less real purchasing power, and the bond cannot be resold except at a loss. A whiff of inflation, and I will sell my bonds, thereby driving up interest rates.
The Fed's job is to prevent inflation, and therefore is the bond investor's best friend. Sure, the bond market can fall apart when the Fed tightens by surprise, as it did in February, 1994. Overconfidence is always vulnerable to surprise.
However, from March, 1994 through January, 1995, the Fed tightened six more times, and the bond market took it in stride, knowing the Fed was trying to limit the inflation danger. The Fed succeeded. Six months after the Fed's last raise of the Fed funds rate, and no reduction, interest rates in the reassured bond and mortgage markets had fallen a percent and a half.
If bond yields rise, as they did in 1994 and this Spring, two very bad things happen to stocks. First, higher bond yields hurt the economy through higher mortgage rates, and a weaker economy means lower corporate earnings. Second, the yield from stock market earnings and price appreciation must maintain pace with the bond market.
A risky 10% return from stocks may beat a bond market yield at 6%, but in the last three years, whenever bond yields have risen above a paltry, but guaranteed 7%, the stock market has had a hard time. It is no accident that this latest, little oops-a-daisy in the stock market immediately followed the Friday, July 5, bond surge to 7.22%. For reference: in the ten months in 1987 before investors pushed the entire stock market off the back of the sled, bond yields rose from 7.45% to 10.17%, two and a half times the 1996 rise.
The interest rates demanded by bond investors are a measure of the Fed's success at controlling the inflation wolf. Mr. Greenspan has a substantial gamble underway, betting that the economy will slow of its own accord later in the year, and the exuberance in the job market will not translate into inflation. The Fed will watch, and wait.
If he's wrongÉ? Well, when the bond market cries "Wolf!" you never know if it's for real until it's too late.
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