The good news is that Tuesday’s report confirming the economy’s outstanding recent productivity performance puts to rest any doubt that the Fed growth jihad is now in abeyance. Year-over-year gains in output per hour of better-than 5%, highest since the opening stages of the Reagan expansion, leaves even the most die-hard Phillips Curver (i.e., Laurence Meyer) without a leg to stand on. Most confounding to the “growth is inflationary” perspective is the fact that productivity has outpaced even the past year’s robust 4.7% rise in wages, resulting in a 0.4% decline in unit labor costs.

The problem is that while relieving the strains posited by the Fed’s lagging, demand-based output-gap model, this backward-looking data means little for future economic performance. Range-bound and highly volatile equities, particularly those of high-risk tech and small-cap issues, though, are telling us that the Fed’s year-long rate-hiking exercise has already spawned considerable uncertainty about the economic outlook. This instability in expectations is likely to prevail in the period immediately ahead.  But the equity market’s rally footing should be restored as it becomes clear that the Fed has pushed short-term rates beyond levels consistent with both non-existent inflation pressures and a slowing economy. Expectations for at least a partial reversal of the 175 basis points in rate hikes should also help power another leg in the impressive advance for long-term bonds, which are up 12.5% on a total return basis so far this year.               

Early hints of such a sentiment shift can already be seen at the short end of the Treasury yield curve, where the 2-year note trades at a 30-35 basis point discount to the 6.5% federal funds rate. Even more striking is the rare divergence of the 2-year from funds-rate expectations discounted in the euro-dollar futures market (see chart). Some analysts suggest that this unhinging from funds-rate fundamentals reflects an overbought situation in shorter maturities, and points to the vulnerability of the entire yield curve to a sharp reversal. More likely, the 2-year note, freed from the rate-hiking pressures of the past year, is now responding to the same forces of dollar strength that presented such compelling value in longer-term Treasuries this year in the face of the Fed’s campaign. This resulted in a 30-year/2-year yield-curve inversion of nearly 80 basis points at its peak in May. While the inversion has flattened out by about 35 basis points since then, it remains an unmistakable indicator of the Fed pushing short rates excessively high relative to the inflation expectations environment. The rally of the two-year to yields consistent with at least one 25-basis point rate cut would tend to confirm that.

2-Year Note and Eurodollar Futures

After falling by some 50 basis points over the past three months to present yields around 5.75%, largely in track with the pricing out of tightening expectations, further upside for the long bond is likely to prove tough to come by in the near-term. But with gold trading in the low $270s and all other forward indicators of dollar purchasing power signaling a continuing dearth of inflation risk, current nominal yields offer attractive value on a real-return basis. That leaves significant additional gains available to be captured as the market and monetary policymakers respond to mounting evidence that price stability is now a practical reality. Certainly, a yield no higher than 5.5% on the long bond by year-end, and 5% by sometime next year, appears within reach.     

In the final analysis, the Fed’s Phillips Curve foray of the past year may prove to have been a necessary part of the transition to a high-growth, no-inflation backdrop for policy.

By conclusively demonstrating the fallaciousness of the purported inflation/unemployment tradeoff, the experience has triggered a period of long-overdue intellectual ferment at the central bank. To his credit, at least Meyer is not intellectually dishonest enough to claim that the rate hikes have been key to maintaining low inflation in the face of 4% unemployment. As recently as two months ago, his textbooks were telling him that avoiding an inflation breakout required lifting unemployment to at least 5%. Now, he has as much as acknowledged that he was wrong, telling a group in Alaska last week that the pace of trend productivity growth allows sustainable expansion of 3.5-4% without inflation. While that still reflects a perspective defined by arbitrary limits, the key point is that these rationalizations signal that the Meyer/Phillips Curve ascendancy at the Fed is in steep decline. Who and/or what will emerge to fill the vacuum remains to be seen, but it can hardly be anything but an improvement.