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This recession and recovery aren't following the path economists had come to expect. In the past, the stock market has almost always anticipated the end of a recession by moving upward before the economy began its ascent. This time, though, the market didn't bottom out until October, 2002, even though the National Bureau of Economic Research recently declared that the official end of the recession came in November, 2001.
The bond market, too, is behaving in peculiar ways. Following the recessions of 1981-82 and 1990-91, long-term interest rates didn't begin to rise until the job market started to recover in earnest. Not so this time. Since July 3, when the June employment report from the Bureau of Labor Statistics confirmed that the economy is still shedding jobs, interest rates on 10-year Treasury bonds have risen sharply, to over 4%. That's still low in historical terms, but it may be enough of an increase to make homeowners less enthusiastic about refinancing.
The combination of rising rates and a weak labor market poses tricky problems for investors and Washington policymakers alike. For investors, the issue is whether they should bet on continued job losses and a sluggish economy, or whether there's a greater probability of faster growth, high deficits, and increased inflation. We think the latter scenario is more likely thanks to lower taxes, higher government spending, and a fast-growing money supply. If that's how events play out, it could send long-term rates soaring to 5% or more very quickly.
As a result, investors should be extremely wary, especially those who, searching for safety, shifted into bond funds after getting burned by the stock market. An increase in interest rates from 4% to 5% on a new 10-year bond would cause roughly a 7%-to-8% drop in the value of the bond investment. That would take a big bite out of wealth.
Policymakers at the Federal Reserve, too, need to pick their way across the economic landscape carefully. They have kept monetary policy very loose and short-term interest rates low to manage the post-boom sluggishness. But it's also worth remembering that higher long-term interest rates generally signal a return to faster growth and higher inflation in the near future. That means, despite publicly worrying about deflation, the central bank may need to refrain from loosening monetary policy any further to avoid letting inflation get a toehold.
In the early 1990s, Democratic political strategist James Carville said that he wanted to be reincarnated as the bond market, because it "can intimidate everybody." Even though its movements are more difficult to decipher now than they were before, when the bond market speaks, it's still wise to listen.