It didn’t take long for the yield on 10-year US Treasuries to drop back below 3 per cent — a level it surpassed last month for the first time since 2014. Not for the first time since the financial crisis, the US bond market confounded gathering bearish sentiment as policy rhetoric at home and unstable capital markets abroad gained prominence. With the next meeting of Federal Reserve policymakers a week away, where do bond markets go next?
The bullish view about bonds is anchored by two observations. First, periods of sub-3 per cent yields are rare. According to Sidney Homer’s History of Interest Rates, you can find them only in the falling price boom at the very end of the 19th century, and then the exceptional circumstances from 1934 to the early 1950s. It is possible then, given low inflation and unusual circumstances, that this time really is different.
Second, going back to the 1960s, the peak in bond yields has coincided mostly with the peak in the Federal Funds rate. On three occasions in the inflation era between 1970 and 1982, the Fed Funds rate peaked well above the 10-year yield. In the 1994 Greenspan bond bear market, the latter peaked almost 3 percentage points above the policy rate. If policymakers’ rate projections to 2019-2020 are right, bond yields have already more or less peaked.
Neither perspective, though, is conclusive because the economic cycle and inflation may yet strengthen, and the structural arguments for low interest rates are still being waged.
US economic growth has been about 2 per cent for a long time, but it may yet quicken. The late-cycle tax cuts are certainly boosting corporate profits and capital spending. Labor market conditions are firm, and unemployment could fall further. The government is also rolling back important aspects of banking and other regulation. Inevitably, there is a darker side to this for markets, too, in the form of fiscal deficits rising to about 5-6 per cent of GDP, even before the onset of the surge in age-related spending, and higher capital costs and inflation deriving from more trade protectionism and a more fragmented direct investment environment.
Yet, however the cycle plays out, investors also need to be focused on what policymakers are thinking about, and that goes by the sci-fi sounding name of R-star. Championed by John Williams, New York Fed president, R-star is the real, or inflation-adjusted, interest rate that occurs when the economy is at full strength. He thinks it’s about 0.5 per cent, about 2 percentage points lower than say 20 years ago, while the median view of policymakers is 0.8 per cent. Add on 2 per cent inflation, and the resting place for policy rates — and bond yields — is roughly 2.5-3 per cent.
R-star is thought to be very skinny nowadays for structural reasons related to demography, productivity and the demand for safe assets. None of these, however, are as cast-iron as is sometimes made out. Any or all could end up changing our thinking about equilibrium rates.
First, demographics point ostensibly to a stagnant and ageing workforce, lower labor market participation and higher levels of savings that should all suppress real rates. Yet, it is far too early to judge, because they also point to skill, educational attainment and wider labor shortages, which would raise returns to labor (higher wages), longer working lives and other phenomena that offset the alleged ageing effects on the economy and on savings.
Second, productivity growth is in a funk, as we know, but the probability is that it will rise again as the adverse legacies of the financial crisis wear off and, importantly, as the pace and diffusion of new technologies pick up. We will have to address the distributional consequences, but the dinosaur consensus on productivity is likely to be wrong. US capital spending trends are certainly encouraging in this respect.
Third, the case for a low real rate, supported by high demand for safe assets relative to supply, is liable to face a big test. Fiscal deficits are going to rise and the Fed’s balance sheet is going to shrink over time. By the Treasury’s estimate, issuance is set to rise from just over $500bn in 2017 to more than $1tn in both 2019 and 2020.
It is undoubtedly true that the world financial system is fraught with risk, and probable that there will be a global economic downturn in the next two to three years. For now, though, it seems complacent to think that policy rates will peak as uneventfully as consensus suggests, or that 3 per cent bond yields mark the top. Caveat emptor.
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