Do Higher Bond Rates Signal A Recovery?

Last week I debated the Federal Reserve's 2010 monetary policy philosophy on CNBC's Kudlow Report with host Larry Kudlow and UC-Irvine business professor Peter Navarro. Since it was one of those segments where you never have enough time to fully address all of the points made, and since I have had a little additional time to reflect on some of what was said, I thought it might be good to provide a more detailed response to a challenge put forth by Kudlow. He says that the bond market is signaling a boom by pushing up interest rates, and that the Fed should follow suit. I disagree and want to better explain why.

First, here's the clip, in case you're dying to see me in action:

Kudlow is one of the most cheery optimists for 2010 I've heard from. Earlier in the show, I believe he said that he expected something like 5% to 6% GDP growth in 2010. I think we'll be lucky if it's half that. He believes that the bond market is signaling this recovery. In the course of the discussion he asks me:

As we come to the end of the year, the whole Treasury interest rate structure has increased by 50, 60 basis points or more. To me that is a signal the Fed should heed. The market is trying to pull the Fed up and the Fed may not be listening, Daniel, what's your take? There are two-year rates, there are five-year rates, and the 10- and 30-year rates. They're all going up. Is that not signaling a boom? Is that not telling the Fed they should follow and start raising their own rate and withdraw and shrink their balance sheet, Daniel?

I don't believe that this is signaling a boom, but would blame a few other factors on why bond yields are increasing.

First, as I noted a week ago, Treasury yields are taking a hit from, both, supply and demand. First, the government is going to flood the market with debt in 2010 to fund all of its spending. With all that supply investors are going to require a better return to soak it all up. Second, they're also going to demand a higher risk premium, as many believe that the U.S. debt levels are getting riskier.

There are other factors driving up rates as well. Inflation expectations are growing, which should also increase the nominal rate for longer-term bonds. The U.S. is pondering historically unprecedented financial regulation, which thrusts a great deal of political uncertainty into the financial markets. That also amounts to a higher risk premium on bonds. Finally, many bond yields were too low prior to the financial crisis, as they didn't properly reflect the risk present in these securities. Investors likely recognize that this must change once Wall Street goes back to business as usual.

So no, I don't think the bond market is simply betting on a huge economic recovery in 2010. And if it is, then, well, I think it's wrong. As I say in the clip, if we've learned anything from the financial crisis, it's that investors aren't as smart as they think and can get things very, embarrassingly wrong. This could be yet another case of irrational exuberance in a sort of mini-bubble.

That's why I don't believe the Fed should follow suit and take drastic action to reduce its balance sheet. I actually worry that ending some of its programs in the first quarter is already a little bit too aggressive. As I've mentioned, I don't see the mortgage-backed securities market comfortably walking on its own two feet in 2010, so mortgage rates could consequently skyrocket, hampering the housing recovery. Consumer credit could also suffer by ending the Fed's Term Asset-Backed Securities Loan Facility, harming spending and GDP growth.

Finally, wish I had posed a question to Kudlow and Navarro: what's worse -- a little bit of inflation, or unemployment increasing to 15% in 2010? I'd prefer the former, but if the Fed drastically reduces its balance sheet -- and we aren't out of the woods -- then the latter could result. I think that the Fed would be taking a huge risk by acting too aggressively to shrink its balance sheet too soon. That could cause the Great Recession to become another Great Depression. I also don't believe that inflation can manifest itself too significantly until the economy has fully recovered. Thus, the risk posed by shrinking monetary supply in 2010 appears far greater than the benefit.