James Baker Redux?

Take a look at a chart of Treasury yields in 1987.  The yield on the 10-year note was around 7 1/4% as the year began, dropped to 7% in late January, and then began a fairly steady rise to around 9 1/2% by mid-September.  That rise was largely in response to the Fed’s pushing the fed funds rate from around 6 1/4% in January to 7 1/4% by September.

By mid-October, however, the 10-year yield was above 10%, reflecting anticipation of more Fed tightening and nervousness about a weak dollar.  That nervousness turned to dismay when, over the weekend of Oct. 17-18, Treasury Secretary James Baker said that the U.S. was happy with a week dollar.  By the morning of Monday, Oct. 19, the dollar and the bond market were in free fall.  The 10-year yield shot well above 10%.  The stock market was also selling off prior to that Monday, but the rout in bonds apparently was the last straw.  By noon on Monday, it was the stock market that was getting all the attention.

Now, we have a Treasury Secretary and a President promoting a weaker dollar at a time when the bond market is anticipating further increases in the fed funds rate.  While rising inflation is not currently a concern, FOMC members cannot be happy about a strategy of imposing tariffs, weakening the currency and expanding the deficit at a time when the economy is at full employment.  Dollar weakness provides more ammunition to those Committee members who argue that financial conditions are easier now than when the fed funds rate was at 1/4%.

The FOMC on Wednesday will almost certainly keep the funds rate unchanged, but the policy statement could easily read more hawkish than six weeks ago.  Economic data have strengthened since the last meeting, the Beige Book found more wage and price pressures and, eventually, tariffs/dollar weakness boost inflation.  A policy of gradual normalization is getting harder to defend.

The State of the Union speech could also be unsettling if the President restates his views on trade and the dollar and promises major infrastructure spending initiatives.

To be sure, economic fundamentals are less bearish for bonds now than in 1987.  Nevertheless, this could be a week in which the bond bulls finally admit that a yield of 3% on the 10-year note cannot be ruled out.


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