The return of the bond market vigilantes

November industrial production was far stronger than expected, rising 1.6% (including upward revisions to prior months) from October levels. This is one more in a growing list of indicators (e.g., bank lending, jobs growth, the ISM manufacturing index, corporate profits, and commercial real estate) which suggest the pace of U.S. economic growth is accelerating after 5 years of relatively tepid 2.3% growth. However, despite evidence of a remarkable and rather broad-based improvement in the economic outlook, the Fed is still reassuring us that monetary policy will be accommodative for a long time to come. The Fed may be asleep at the switch, but, fortunately, not the bond market vigilantes.

U.S. industrial production is up a strong 5.2%% in the past year, and over the past six months it has increased at a 5.8% annualized pace. The Eurozone, unfortunately, continues to languish. The huge and growing gap between economic conditions here and in the Eurozone helps explain why the dollar has risen almost 20% vis a vis the Euro since 2011. The dollar's strength says more about the relative strength of the U.S. economy than it does about the Fed's monetary policy. But it does jibe with the market's expectation that the Fed is quite likely to begin raising rates in the foreseeable future, whereas the ECB is being forced to resort to more QE.

Activity in the mining sector has softened in recent months, falling by roughly 1%, no doubt due to the sharp decline in oil prices which has surely all-but-halted new drilling and exploration in the sector. The chart above—which excludes the mining and utility sectors—shows strong gains in manufacturing production, which is up 4.7% in the past year, and up at a 5.5% pace in the past six months. Manufacturing production has finally hit a new all-time high. 

The story is the same for business equipment production, shown in the chart above. It's up a very strong 6.5% in the past year. The U.S. economy will do just fine even if the mining sector stops growing.

According to the Fed (caveat: the Fed can only estimate, not actually measure capacity utilization) capacity utilization rates in the industrial sector of the economy have reached a post-recession high. As the chart above shows, capacity utilization rates today are almost as strong as they were before the Great Recession. Notably, the Fed's monetary policy stance (as reflected in the red line, which is the real Fed funds rate) has been very accommodative for a very long time. In past recoveries, the Fed responded much quicker to strength in the industrial sector—by tightening policy—than it has this time. This implies that the Fed is running the risk of being "too easy for too long." That (waiting too long to tighten) was one of the mistakes that contributed to the Great Recession and the rise in inflation which followed. Recall that the Fed held rates at 1% from mid-2003 to mid-2004, then began a slow-and-steady policy of raising rates for the next two years. The CPI rose from less than 2% in early 2004 to a peak of 5.6% in mid-2008 (a typically delayed response to a monetary policy error).

Fortunately, the bond market vigilantes are not asleep at the switch or fearful of the wrath of politicians. Since the end of June, as the chart above shows, real yields on 5-yr TIPS are up 85 bps. The bond market is coming down firmly on the side of an acceleration in economic activity. 

The bond market's energetic response to a quickening in the pace of economic activity has gone largely unnoticed, however, because—thanks to plunging oil prices—inflation expectations have declined by almost 1% since June. As the chart above shows, nominal yields have been flat while real yields have risen: last June, the expected rate of inflation embodied in 5-yr TIPS and Treasury prices was 2.14%, and today it is 1.23%. Don't look at nominal yields, look at real yields if you want the "real" story. Real yields are increasing because growth expectations are firming. Nominal yields are not increasing (and in the case of 10-yr Treasury yields, they have fallen by 50 bps since June) because inflation expectations have fallen.

Stronger growth and lower inflation is a terrific combination. But to judge from our skittish equity and corporate bond markets, it's not yet fully appreciated.