While equity market euphoria at the prospect of President Donald Trump’s spendthrift, deregulatory agenda remains undimmed, bond investors are sending a very different message.
US equity gauges have continued to climb this year, propelled by hopes of deregulation, tax cuts, government spending and more business-friendly policies. This week all four of the biggest stock indices achieved yet another “Grand Slam” of fresh records in the wake of President Trump’s speech to Congress earlier this week.
In contrast, there are few signs that fixed income investors think the new administration will be able to jump-start the economy, leading to a durable growth spurt and ultimately much higher interest rates.
“The bond market is taking a totally different view from the equity market. Blowing raspberries is a good way to put it,” says Jim McCaughan, chief executive of Principal Global Investors. “There’s no belief that the growth agenda will be dramatic.”
The pessimism is longstanding and in part reflects structural challenges facing the US economy, such as falling productivity and ageing populations, as well as a global savings glut that subdues bond yields.
The elderly work less and tend to save more, and stash more of their money in safer assets like bonds. This saps an economy of its vim and helps pin down yields. Moreover, many countries and companies are also in savings mode, sustaining demand for ultra-safe assets like Treasuries.
The dour bond market view on the long-term outlook for the economy is best illustrated by the “natural” or “neutral” real interest rate, a steady-state level where rates neither stimulate nor constrict the economy.
This is a topic that has consumed some asset managers, economists and Federal Reserve officials in recent years, and many investors now simply refer to the natural real interest rate as “r*”, economics jargon where the “r” stands for interest rates and the star shows its long-term nature. “Real” means after it is adjusted for inflation.
As economists and markets became progressively glummer on the future prospects of the US economy, estimates of the natural interest rate were trimmed again and again, not least by the Fed itself.
The latest Fed forecasts indicate that most officials think r* is now 3 per cent (before inflation), compared with more than 4 per cent just a few years ago. But some officials are even glummer.
“There is a range of estimates for the current neutral real rate. Having looked at them, I tend to think it is around zero today, or perhaps slightly negative,” Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, wrote in a recent blog post.
The best gauge for where investors see the natural interest rate is the 10-year Treasury forward contract, a long-term bond derivative that shows what investors think the 10-year Treasury yield will be in a decade’s time.
Expressed as the 10y10y forward rate, it has climbed sharply since plumbing a record low of just 2.6 per cent last summer, especially in the wake of Donald Trump’s presidential election. But lately the measure has flatlined at about 3.6 per cent, compared with its long-term average of about 5.5 per cent.
Assuming a long-run inflation rate of about 2 per cent, this indicates investors think the real neutral rate currently sits around 1.6 per cent.
This is not a mere academic discussion, as the natural interest rate is vital for the Fed in deciding how quickly and aggressively it can raise its own benchmark rate and trim its bloated balance sheet without slowing the economy and ushering a recession. A lower rate indicates a lack of economic optimism.
Shorter-term measures also underscore the glumness. The 10-year Treasury yield is expected to be just 2.6 per cent in a year’s time, even below the roughly 3 per cent level that most economists are forecasting. Moreover, almost the entire rise in forward yields can be accounted for by a rise in inflation expectations rather than rising economic expectations.
The yield curve — the relationship derived from the various maturities of Treasury bonds — also signals a subdued outlook. The difference between two- and 30-year Treasury yields stands at just 176 basis points, not far from the nine-year low of 140bp touched last August.
“I’m sceptical because the structural reasons that have driven yields down to the ground are still there, and if anything they will get more powerful,” says Edward Al-Hussainy, a senior global rates analyst at Columbia Threadneedle.
Japan could be a canary in the coal mine. Japanese bond yields headed south for decades despite strenuous, repeated attempts to reinvigorate growth and inflation. Improving productivity would be a boon to longer-term growth, and therefore lift the neutral rate but is easier said than done.
Mr Hussainy points out that while equity markets may be excited about the prospects of deregulation and tax cuts, there is relatively little so far in the new administration’s spending plans that would indicate measures to invigorate long-term US economic potential.
“We’re not building more schools, it seems we’re just building more nukes, so it’s hard to get excited about productivity then,” he says.