A Reaffirmation on Bonds Jude Wanniski March 7, 1990

Last month, we clearly indicated the bullishness we felt as a result of reading the Fed's December minutes, released the same day. The minutes revealed that Governor Wayne Angell had taken an enormous gamble on his price-level target model, predicting that if his fellow FOMC members voted to ease, adding reserves to bring down the fed funds rate, the action "would tend to accommodate rising prices, foster uncertainty in the financial markets, and drive up long-term interest rates." In his four years at the Fed, Angell had never dissented on monetary policy, and he was alone in his view. The vote was 9-to-2 to ease, but the other dissenting vote came from Thomas Meltzer of the St. Louis Fed, whose reasoning was diametrically opposed to Angell's. Meltzer wanted short-rates to remain tight in order to slow the economy, adhering to the monetarist version of the Phillips Curve; Angell's argument was clearly to keep short-rates firm in order to assure the bond market that the Fed was not going to inflate. As he argued, this would keep long rates from rising, with positive effects on the economy!

Within three weeks, as the bond market nose dived and long-term rates soared to 8.6% from 7.8%, Angell had won his crucial bet. If he had lost -- if the bond market approved of the easing -- he would now be the object of ridicule and scorn. His price-level target model would be out the window. Instead, Vice Chairman Manuel Johnson, within weeks of the move, publicly acknowledged in a clear although oblique manner that Angell was right. Fed Chairman Greenspan, who does not like to acknowledge error, immediately latched on to the idea that the bond market turned south because it suddenly realized East Germany would soon put enormous demands on world capital sources. This ridiculous idea, which permeates the financial press, once again demonstrates that Greenspan hasn't learned much in his three years at the Fed. After V-E Day in 1945, almost all of Europe and Asia was bombed out, with monumental demands on global capital, yet U.S. interest rates did not rise a whisker. East Germany's capital demands are trivial by comparison, as Angell has pointed out, yet Greenspan and the Beltway Keynesians blame the worldwide rise in interest rates on it. In fact, the Eastern Bloc's break from the communist idea means the liberation of the capital assets of its people and its land. Can you imagine interest rates rising in Europe in 1493, after news arrived of the New World, with its enormous capital demands?

As the significance of Angell's victory sinks into the markets, the seeming linkage of U.S. interest rates to Germany's and Japan's has waned. The price of gold, which had been flirting with $425, has now reached $400. With Angell now in the driver's seat and Johnson riding shotgun, the U.S. economy can begin to lift itself out of the inventory shallows that emerged after the October mini-crash. Greenspan is still confusing the markets by linking inflation and growth in his public pronouncements. Investors must worry that as this new growth makes its appearance, with the first robin of spring, Greenspan will try to shoot it down to fight inflation. Another way of saying this is that as the demand for dollars picks up with this new springtime growth, the Fed will have to add liquidity to accommodate it, or the price of gold will continue to fall. Angell and Johnson, we can be sure, will shift to this accommodative policy -- before gold hits $350, we can assume. I'm really saying that I believe gold will continue to drift lower and that bonds are getting to look better and better. Once the market gets a clear signal that Angell and Johnson will vote to ease even though the economic signals are growing stronger, we should have a major rally.

What of Japan? I remain convinced that the turmoil in the Tokyo markets is entirely due to Washington's clubbing of Tokyo over trade. Because Japan has no way to fight back, as it did in 1941, all it can do is what the Bush administration demands of it, or simply take the clubbing. As matters stand, unless Japan permits Treasury's David Mulford and USTR Carla Hills to dictate its domestic policy — regarding taxes, trade and money -- it will have to absorb the sanctions the U.S. is now threatening. The Tokyo markets certainly were not encouraged by the Bush-Kaifu summit in Palm Springs, and nothing we've heard out of the meeting indicates that any progress was made in avoiding the June deadline.

Picture one man clubbing another man who is defenseless, and you can see Japan preparing to take the blow, cringing, holding up its arms, bowing its head. The plunging Nikkei Dow is simply discounting the economic effects of the June sanctions that Kaifu has no choice but to see fall on him. The Japanese people cannot permit their democracy to be nullified by the arrogance of power in Washington. Is it any wonder the demand for yen is falling, as the markets see the Japanese economy hurled into a trade recession? Should the Bank of Japan raise the discount rate, as it threatens to do in order to defend the yen? One way or another, it will not matter much, I think, as there is little it can achieve through monetary policy to soften the trade blows being readied by Washington.

The one hope I see to diffuse this very nasty confrontation with Japan is the Secretary of State, James Baker III. It has been Baker's strategy since 1987 to throw enough red meat to the Gephardt nationalists in the U.S. Congress to keep them occupied. Baker saw Democratic protectionism as a threat to Bush's election in 1988, which is why I think he caved in to the onerous provisions of the Trade Act of 1988, hoping to defuse trade as a campaign issue. We can appreciate that if he were unsure of how the issue would cut, he would hedge, as he did, arguing that as President, George Bush would be able to contain the protectionist wolves.

At the moment I'm not sure Baker is in control on trade, or that he wants to be in control, or that he can wrestle it away from Nick Brady, John Sununu, David Mulford, Carla Hills, and the other relative hardliners in the administration. We know Dan Quayle, Michael Boskin, Richard Darman, and Robert Zoellick (JBIII's counselor), would like to find a way to diffuse the conflict. But we don't know if JBIII himself is prepared to take the lead. If he decides to sit this out, because it is too hot to handle, we can expect further turbulence in Tokyo.

On the other hand, if JBIII weighs in, almost certainly he has the resources to yank out the fuse before this trade bomb goes off, with plenty of shrapnel falling on Wall Street in the process. If we see signs of JBIII weighing in, we would immediately become as bullish about the Nikkei Dow and the yen as we are now about U.S. bonds, with Angell having stepped up, gambled and won.