Economists may warn that the combination of Trump’s protectionism, big tax cuts, and uncontrolled government borrowing, coming at a time when the US economy is already near full employment, will ultimately fuel inflationary pressure. But financial markets simply do not believe this message, writes Anatole Kaletsk, Chief Economist and Co-Chairman of Gavekal Dragonomics.
As U.S. President Donald Trump ratchets up his trade war with China and the Federal Reserve Board increases U.S. interest rates, the prospects for the world economy and financial markets, so bright just a few months ago, appear to be darkening. Stock markets around the world have fallen back toward their February lows, business confidence has weakened in Europe and much of Asia, and policymakers worldwide are making nervous noises. Are these events the beginning of the end of the global economic expansion, or is the recent market turbulence just a false alarm?
Last month, I highlighted three indicators – the oil price, long-term US interest rates, and the dollar’s exchange rate – suggesting that global conditions would remain benign. Economists may warn that the combination of Trump’s protectionism, big tax cuts, and uncontrolled government borrowing, coming at a time when the US economy is already near full employment, will ultimately fuel inflationary pressure. But financial markets simply do not believe this message. And since the financial turbulence of early February, the message from the biggest and most important financial market – for US government bonds – has become even more reassuring.
Despite the Fed’s decision to raise short-term interest rates, and to signal more rate hikes than expected for 2019, interest rates on US ten-year bonds have fallen to levels well below their February peak. Thirty-year interest rates are now below their 2017 peak of around 3.25%. These interest-rate movements imply that bond investors are less worried today about inflation and economic overheating than they were before Trump’s tax cuts, protectionist measures, and the shift from budget consolidation to aggressive fiscal expansion.
The fact that bond investors seem unworried about inflation or overheating does not mean that Trump’s protectionism and fiscal profligacy are harmless. Financial markets are sometimes catastrophically wrong, as they were before the 2007-08 financial crisis. But the U.S. bond market is more than just an indicator of financial opinion. The long-term interest rates set in bond markets have so much impact on business conditions that changes in investors’ views can influence economic reality almost as much as vice versa.
At present, investors’ views and economic reality are completely at odds. Long-term interest rates of around 3% come nowhere near pricing in the Fed’s inflation target of 2% plus the real economic growth of 2-3% that was likely to be achieved even before the Trump administration’s big fiscal stimulus. In fact, both economic analysis and decades of past experience suggest that long-term interest rates tend to fluctuate around the rate of nominal GDP growth. This rule of thumb implies 30-year rates in the 4-5% range. And if Trump’s efforts to boost economic growth toward 4% were taken seriously, long-term interest rates should logically rise to 6% or above.
Sooner or later, the gap between bond yields and nominal GDP growth will presumably close. Either growth will weaken dramatically, as implied by bond-market expectations, or interest rates will rise dramatically, because bond-market expectations turn out to be completely wrong.
And yet neither of these things will necessarily happen in the next year or two. GDP growth is unlikely to weaken, given the big fiscal stimulus, very high business confidence, and strong growth in personal incomes resulting from rapid job growth.
But what about bond yields? If the U.S. economy continues growing as expected, is it not inevitable that long-term interest rates will surge to much higher levels, knocking the highly leveraged US, and ultimately the entire world economy, off its current path of strong and stable growth?
This seems unlikely, at least in the year ahead, for several related reasons. First and foremost, the belief in a “new normal” of anemic growth and low inflation is deeply embedded among investors and central bankers. After spending the decade since the financial crisis obsessing about secular stagnation and falling prices, investors and Federal Reserve officials will require many months or even years of consistent and incontrovertible evidence of inflation and higher growth to be convinced that deflationary conditions have genuinely reversed.
Even when investors accept the intellectual case for much higher bond yields, regulatory impositions on banks and pension funds, together with quantitative easing in Japan and Europe and other forms of financial repression, will ensure continuing demand for government bonds at prices far above any reasonable estimate of fundamental values.
The distorted pricing cause by regulatory pressures is amplified by a kind of conditioned response among bond investors. As inflation and interest rates have fallen steadily over the past 30 years, bond investors have been consistently rewarded for treating every temporary uptick in interest rates as a buying opportunity. This experience has created a Pavlovian reflex to “buy on dips” that can be broken only by many months or perhaps even years of negative experience. This reflex has been strongly apparent in the past two months. Whenever stock markets have fallen sharply, as they did in early February and again after Trump announced his trade sanctions on China, the bond-buying instinct became irresistible, bond prices rallied, and the resulting reductions in long-term interest rates stabilized stock markets.
At some point, the bond market’s Pavlovian behavior will stop, and long-term interest rates will move much higher. But until this happens, investors’ unshakable belief that low inflation is a permanent feature of economic reality will allow the US government to pursue increasingly inflationary policies. And the bizarrely low long-term interest rates set by complacent bond markets will provide a safety net for global financial markets – at least until complacency proves to be unsustainable.
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