The sharp sell off in the US bond market last week was partly due to a correction from extreme market positioning, but deeper economic fundamentals were also important. According to the latest Fulcrum nowcasts, US activity is now far stronger (relative to the underlying trend) than in other major economies.
Furthermore, Federal Reserve chairman Jay Powell seems to be increasingly optimistic that the US expansion can be sustained for a very long period ahead, with only a moderate risk that this will cause a sudden pick up in price inflation.
Until now, bond markets have believed that a US downturn may occur before too long, with many analysts predicting (with spurious precision) that a recession will start in 2020, when the fiscal stimulus ends.
Last week, Mr Powell showed absolutely no sympathy with this pessimistic point of view. He may be underestimating the inflation risk from rising wages in the next couple of years, but for now there is little likelihood that a hostile Fed will kill the prolonged American recovery.
The latest monthly report from the Fulcrum nowcasts identifies two main themes in global activity. The first is that the global growth rate has slowed from 4.5 per cent in mid year to 4.0 per cent, which is almost exactly its trend rate.
This drop in growth has triggered concerns in policy circles that the world upswing has now plateaued. For example, Christine Lagarde of the IMF has warned that her organisation will downgrade its projections for growth in Europe and China at the annual meetings next week. She mentioned the uncertainties surrounding trade barriers, and the tightening of monetary conditions in emerging economies, as the main reasons for diminished optimism about global growth.
The second main theme is that US growth has diverged sharply from other major economies. While the rest of the world has recorded a decline in growth relative to trend of around half a percentage point since August, US activity has rebounded by a full percentage point.
This leaves the US as the only major economy that is still growing at well above trend rates, in fact at 4.1 per cent. It also means that the American labour market and capacity utilisation are both tightening more rapidly than expected by the consensus of independent forecasters.
By contrast, growth in the euro area (at 1.6 per cent), Japan (0.7 per cent) and China (6.9 per cent) have now all subsided back to their trend rates, and are widely expected to drop further in the next few months. Furthermore, weakness in other emerging economies, notably Brazil, is dragging the global growth rate downwards.
Global growth in the goods sector has weakened since mid year, and there still seems to be some overhang of excess inventories in the system. These downside risks to manufacturing activity warrant close attention in coming months.
In addition to strong US activity data, the outsized response of bond yields last week was triggered by some interesting changes in Fed guidance on the economy and monetary policy.
As noted above, Mr Powell made some surprising comments about the US upswing “continuing indefinitely”. Although that was not meant literally, he obviously sees nothing inevitable about a US recession within the Fed’s usual two-year policy horizon.
The Fed’s leadership has also made some important remarks about its approach to the equilibrium rate of interest, or r*. Both Mr Powell and New York Fed President John Williams (the Fed’s in house guru on the subject) have emphasised that the measurement of r* involves great uncertainty, implying that the concept should not be seen as a very reliable guide to policy at present.
These remarks are completely at odds with the Fed’s approach to r* in recent years, when the concept was routinely used to argue that monetary policy was deliberately being held highly accommodative relative to equilibrium (see Tim Duy).
Two factors account for this change:
However, there is an important distinction between a gradual pace of rate rises, and the terminal rate that will be reached at the end of the cycle. It is the market’s expectation of the terminal rate that mainly determines the long term bond yield at any given time.
Perhaps inadvertently, Mr Powell’s recent remarks have increased market uncertainty about the terminal rate. Previously, investors expected r* to act as a barrier to further rate rises once it has been reached, because the FOMC was considered reluctant to push monetary policy too far into contractionary territory. To the extent that r* is downplayed, there is less of a psychological barrier to additional rate rises before the cycle ends.
The bond market now has to cope with Fed guidance that describes the American expansion as very prolonged, with no clear terminal level for the policy rate. That combination could shake confidence, especially with wages rising.
Mr Powell may have to change his rhetoric to put the lid back on the long bond yield.