“Waiting too long to begin moving toward the neutral rate couldrisk a nasty surprise down the road – either too much inflation,financial instability, or both.”
—Federal Reserve Chair Janet Yellen, 18 January 2017
When there is fear of inflation on the streets of the bond market, a copneeds to walk the beat; otherwise, bond investors take matters into theirown hands. Without proper policing from the Federal Reserve, bond investorstypically begin demanding higher interest rates to compensate them for therisk that inflation will accelerate and that the acceleration willeventually force the Federal Reserve to raise interest rates more thanexpected.
This is one reason why bond yields have climbed of late: Many investorsworry the Trump administration will take actions to promote faster U.S.economic growth at a time when, as Fed Chair Yellen recently said, it isn’tobvious that fiscal measures are needed to reduce the jobless rate furtherfrom an already low 4.8%. More downward pressure on the unemployment ratecould boost wages, strain employers’ resources and stoke inflation (Figure1).
Fear of faster inflation is why a hawkish Fed – a Fed that warns it mayincrease its policy rate more than markets expect in the near term– can ultimately be good for the bond market. A hawkish Fed cancalm fears of economic overheating and thereby steer bond investors’ viewson the long-term path for the Fed’s policy rate, thefederal funds rate.
Judging by current market levels, investors today see the fed funds raterising to around 2% by 2020, well below the peaks of 5.25%, 6.5% and 6.0%for the rate-hike cycles that ended in 2006, 2000 and 1995, respectively.In this vein, we think the Fed’s mantra should be “protect the path” ‒protect the current view that its policy rate will stay low for the rest ofthe decade and beyond ‒ to minimize the risk of financial instability thatmuch higher market interest rates could potentially bring.
In contrast, if the Fed takes a dovish stance now despite signs that theU.S. has reached full employment, and is therefore slow to shift its focustoward the inflation side of its dual mandate, this could ultimately be bad for the bond market; bond market “vigilantes” would likelypush market rates higher, creating volatility. Only when the Fed returns tothe beat and engages the bond market’s nemesis – inflation ‒ will thevigilantes relent.
The Fed has successfully contained inflation fears in the past by taking ahawkish stance. For example, in November 1994 the Fed, then under theleadership of Alan Greenspan, moved decisively to address inflation fearsby announcing a whopping 75-basis-point rate hike, which sparked a big rally in the bond market, taking many by surprise. A little toughlove can go a long way in the bond market.
Yellen’s Costanza moment
In a famous episode of the popular U.S. television series “Seinfeld,” thehapless character George Costanza finds that by doing the oppositeof what he ordinarily does, he actually gets what he wants.
For the Fed to get what it wants – maximum employment alongside pricestability – it could do the opposite of what it has typically done duringthe post-crisis period to temper the bond market’s view of how high thefederal funds rate will go.
Specifically, in recent years, the Fed has repeatedly reassured investorsthat rates would stay low for some time – a dovish stance at a time whenmore hawkish talk and actions would have been detrimental to markets andthe struggling economy. Today, a more hawkish approach may be warranted.Alternatively, if the Fed’s focus does not shift to taming inflation, bondmarket vigilantes will likely look to drive yields higher, effectivelytightening policy for the Fed and arresting inflation on their own, butalso creating uncertainty over the future path for interest rates.
Bond market volatility: taking the long-term view
Arguably, the biggest investment implication of the recent U.S. electionwill be a likely pivot away from central bank dominance to fiscaldominance. As the task of promoting economic growth shifts from the Fed toU.S. fiscal authorities, an upward bias is likely in U.S. economic growth,inflation and bond yields.
Already, the bond market has experienced a “Trumponomics Tantrum,” with theU.S. 10-year Treasury yield moving to about 2.6% from 1.85% since theelection (Figure 2).
Rising Treasury yields also currently reflect uncertainty about the degree of change to the outlook. Investors are reintroducing riskpremiums into the bond market – the extra yield that compensates them foruncertainty. Risk premiums have been very low for years, in part due to thedysfunction in Washington that made the Fed the only game in town.
What’s next for U.S. Treasuries and the bond market more broadly?
The answer lies in whether the government is able to permanentlyalter the U.S. growth trajectory. To do so, the U.S. must overcomeheadwinds from demographics and indebtedness and bolster the sagging growthrate in U.S. productivity, which is the defining indicator of changes tothe nation’s standard of living. This is a big undertaking, requiring afocus on the long-term drivers of growth, such as education andinvestment. Only if productivity improves will bond yields move appreciablyand sustainably higher. For now, markets are appropriately skeptical,priced for the Fed’s policy rate to end the decade at around just 2%.
Investors should therefore focus on the quality of forthcomingfiscal endeavors. For example, will the U.S. choose the big, bold projectssuch as the Dwight D. Eisenhower Interstate Highway System, which producedsome 50,000 miles of roadway that Americans still benefit from today(Figure 3), or will it choose low value-added projects similar to thosethat were crafted for the American Recovery and Reinvestment Act of 2009?
For now, we think a “show me” mindset is warranted.
Trumponomics alone will likely not be enough to sustain a significantincrease in yields, owing to deep structural influences at play in not justthe U.S. but the rest of the world, which will limit the extent to whichthe Fed can raise rates.
We think global influences will bias yields downward for the rest of the decade, in particular the Bank of Japan’s promise tokeep Japan’s 10-year bond yield capped at around 0%, as well as zero ornear-zero policy rates in Europe. Other major global yield suppressorsinclude powerful and irreversible demographic influences, weak global moneycreation, cautious consumer behavior and China’s transition to aconsumer-led economy, which will take time and limit new vigor in theglobal economy.
The New Normal is still valid
While the potential for fiscal stimulus points to a relatively strongcyclical outlook for the U.S., in order for it to last the U.S. mustaddress deep-rooted domestic factors that are stymieing growth inproductivity, in particular weak growth in investment in people and in“stuff” ‒ plants, equipment, software, structures and infrastructure.Capital investment is one of the three major sources of productivity, alongwith human capital and how people use their skills and the nation’s capitalstock to produce goods and services.
Capital intensity, which measures the amount of capital in placeper unit of labor, fell year-over-year last year for the first time sinceat least 1953 (Figure 4). This decline is akin to a company with 100employees and 50 computers one year ago having 100 people and 48 computerstoday ‒ clearly a negative development for productivity and growth.
It is notable that Yellen, ina speech in Wyoming on 26 August, said faster U.S. productivity growth would “raise the average level ofinterest rates.” Therein lies perhaps the biggest key to the long-termoutlook on U.S. rates. Yellen knows, as bond investors do, that fasterproductivity results in faster income growth and higher levels of aggregatespending, which can boost inflation and interest rates.
Attaining faster productivity in the U.S. will be no small task given thenation’s high level of indebtedness, its rapidly growing entitlementsobligations and the political difficulties of channeling the nation’sresources into endeavors whose benefits will in some cases extend beyondthe political lives of those in power.
For many reasons, then, it is fair to say that the New Normal foreconomic growth – the era of slower-than-historical growth – remainsvalid.Therefore, the bond market’s current benign outlook for the Fed’s policyrate is rational.
In sum, the rate outlook will not change much unless one of three thingshappens. First, the Fed would have to fail to shift its focus to inflationin a timely manner, altering the bond market’s benign outlook on the pathfor the fed funds rate. Second, the bond market would need to be convincedthat fiscal initiatives will cause a permanent change in the U.S. growth trajectory. The thirdwould be a change in the outlook for global policy rates, which isunlikely.
In this uncertain time, we think portfolio diversification is crucial andcaution against trying to time the vacillations in the bond market whenaiming to achieve it. Investors may want to think long term and welcome the rise in yields, which over the long run should boostreturns, and take advantage of market volatility when prices deviate fromfundamentals.