Bond Market Forecast Bad Economic News


With the best job growth in over 40 years, inflation a national obsession and the Federal Reserve preparing to raise interest rates, it’s easy to forget how different the world was before the pandemic. . The global environment was then marked by sluggish growth, sluggish investment, worrying inflation and low interest rates.

Which could be where the United States is heading again.

The bond market seems to be betting on it. Even with US inflation close to 40 years at 7%, 10-year Treasury yields are below 2%. Real bond yields, i.e. adjusted for expected future inflation, are negative 0.2% and have been mostly negative since the start of the pandemic, the second such episode in 30 years only.

Even as the Fed steps up its interest rate hike plans, markets have revised down the level they are likely to reach. They see the federal funds rate, now close to zero, reaching just 2% in 2025, which would be slightly negative in real terms.

Investors, of course, can simply be wrong. Since the beginning of the year, investors seem to have reassessed the outlook for interest rates. Bonds sold off, with the 10-year Treasury yield moving in the opposite direction to its price, jumping to 1.7% from 1.5% at the end of 2021.

The Federal Reserve Building in Washington, DC The Fed advanced its interest rate hike plans, but markets downgraded their likely level.


Photo:

Stefani Reynolds/Bloomberg News

Still, there’s good reason to think that today’s sizzling economy may just be a temporary respite. In the longer term, real yields have been declining for decades. Olivier Blanchard, the former chief economist of the International Monetary Fund, makes this point in a new book, “Fiscal Policy Under Low Interest Rates.” In it, he notes that safe interest rates – in other words, those on risk-free government debt – have been falling in the United States, Western Europe and Japan for 30 years. “Their decline is due neither to the global financial crisis of the late 2000s nor to the current Covid crisis, but to more persistent factors,” he writes. “Something has happened in the past 30 years that is different from the past.”

Several years ago, former Treasury Secretary Larry Summers argued that a persistent investment shortfall amid a global savings glut was holding up both growth and interest rates, a situation which he called “secular stagnation”, a term first used in the 1930s.

“Secular stagnation was the problem of the moment in the late 1930s,” Summers said at the Wall Street Journal’s Council of CEOs Summit in December. “Once rearmament and World War II started, and there was a massive fiscal expansion, that was no longer the issue. Similarly, after we had a 15% fiscal expansion of GDP, secular stagnation is not the current problem.

During a confirmation hearing for his second term as Federal Reserve Chairman, Jerome Powell said the central bank would use its tools to rein in inflation. Photo: Graeme Jennings/Press Pool

New warnings

That’s why, early last year, Mr Summers went from warning about secular stagnation to warning that fiscal and monetary stimulus threatened to push inflation up sharply. Still, he thinks it’s more likely than not that secular stagnation will return in a few years: It’s a “natural interpretation” of why markets expect real interest rates to stay so low, he said.

Slow signals

Interest rates and demographics indicate that the current moment of high inflation and high growth may not last

Real 10-year Treasury yield

Expected Federal Funds Rate

Peak rate expectations have eased since June

10-year treasury bill yield less the expected 10-year inflation rate*

Day before the June FOMC meeting

Inflation-Linked Bond Yield

Real 10-year Treasury yield

Expected Federal Funds Rate

Peak rate expectations have eased since June

Minus 10-year Treasury yield

the expected inflation rate over 10 years*

eve of june

FOMC meeting

Indexed to inflation

bond yield

Real 10-year Treasury yield

10-year treasury bill yield less the expected 10-year inflation rate*

Inflation-Linked Bond Yield

Expected Federal Funds Rate

Peak rate expectations have eased since June

Day before the June FOMC meeting

Real 10-year Treasury yield

10-year treasury bill yield less the expected 10-year inflation rate*

Inflation-Linked Bond Yield

Expected Federal Funds Rate

Peak rate expectations have eased since June

Day before the June FOMC meeting

Real 10-year Treasury yield

10-year treasury bill yield less the expected 10-year inflation rate*

Inflation-Linked Bond Yield

Expected Federal Funds Rate

Peak rate expectations have eased since June

Day before the June FOMC meeting

This possibility also weighs on the minds of Fed officials. Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, said supporting higher rates this year was weighing two opposing risks. The first is that high inflation becomes embedded in public behavior, necessitating even higher interest rates later on. The other is that after the passage of Covid-19, the world returns to the pre-pandemic regime of low growth and low inflation. This diet, he writes on the Medium publishing site, was driven by “Demographic, business and technological factors. It is unlikely that these underlying forces have disappeared.

Slowing population growth reduces demand for cars, homes and other durable goods, as well as the need for businesses to expand capacity. Longer life expectancies mean people are spending more of their lives in retirement, so they are saving more in anticipation. Together, these effects tend to keep interest rates low.

The pandemic has intensified the trend of slowing population growth around the world. The US population grew just 0.1% in the year to July – the slowest on record – as birth rates and immigration fell. With retirements accelerating due to the pandemic, the US labor force ended last year down 1.4% from pre-pandemic levels.

China’s population barely grew in 2020, and its population in the 15-59 age bracket fell by 5% over the previous decade. The government reacted with concern. A state-backed newspaper briefly urged Communist Party members to have more children, and access to vasectomy and abortion reportedly declined.

A blow to productivity

Besides population, the main contributor to growth is productivity, and this also appears to have suffered during the pandemic. As businesses have stepped up digitalization by investing more in e-commerce, cloud computing and artificial intelligence, productivity has suffered further due to Covid-19 protocols and restrictions, and drastic changes in the place and the choice of people to work with. The recent rise in inflation suggests that the United States cannot grow as rapidly as before without straining its productive capacity. Some of these barriers to growth will likely persist even after the pandemic is over.

Meanwhile, Chinese investment has slowed under the impact of its own Covid-19 restrictions and a cooling property sector. As a result, its excess savings are again recycled to the rest of the world. One indicator of that surplus, China’s trade surplus, rose 53% in the 12 months to November to $673 billion from two years earlier. These surpluses are likely to continue if the shrinking labor force and reduced real estate investment continue to weigh on Chinese domestic demand.

A supermarket in Clark, NJ For now, rising prices at the store have made Americans very inflation conscious.


Photo:

Michael Loccisano/Getty Images

A return to a world of low growth, low inflation and low interest rates has a silver lining. This would mean that valuations of rich assets are less likely to represent a bubble. Stocks are trading at near-record price-to-earnings ratios, but these ratios are justifiable if real interest rates stay around zero. The federal debt, which since 2019 has risen from 80% to around 100% of GDP, is more easily sustainable with low rates, even if slower growth works in the opposite direction. Indeed, one reason interest rates may be low is because investors think the Fed won’t raise them as much for fear of a stock market crash. It raised rates above 2.25% in 2018, then reversed course as equity and commodity markets faltered.

What happens if investment and economic growth weaken, but inflation remains high? If inflation stabilizes at, say, 3.5%, as some economists expect, then bond yields could also double to 3.5%, with real rates remaining at zero. In the United States, however, high and volatile inflation eventually drove real interest rates higher, while in other countries such as Japan, stagnant growth and low inflation went hand in hand.

For now, investors believe inflation is falling and will average 2.5% over the next 10 years, based on both regular and inflation-linked bond yields. But Joe Gagnon, an economist at the Peterson Institute for International Economics, warns: “Bond markets have never predicted an inflation explosion. So why would we think they can now? He adds: “They react very quickly when inflation starts to rise.”

Mr. Ip is the Wall Street Journal’s chief economics commentator. He can be contacted at [email protected].

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