Fixed income and equities linked by low inflation expectations
The US yield curve is flattening to an extent not seen since 2007. The flattening of the yield curve is often considered a sign that the economic cycle is maturing, as it comes with tighter monetary policy. The inversion of the curve is considered a bellwether of a recession. Meanwhile, long bond yields are currently very low, at 2.35 % on 10-year maturities, vs. a 4 % average in 2007.
Michala Marcussen, Societe Generale’s Group Chief Economist.
The contrast between, on the one hand, low interest rates and the current flattening of the yield curve and, on the other hand, the solid performance by US equity markets (up by almost 20 % on the year to date) is an enigma. There are few signs that equity investors believe the current expansion will come to an end any time soon. To get to the bottom of this enigma, it is useful to look at the traditional breakdown of bond yields into their three main components: (1) expectations of real monetary policy rates; (2) inflation expectations; and (3) the term premium, which reflects perceived uncertainty in future trends of the first two components.
The first factor is low expectations for real monetary policy rates or, in a medium-term outlook, the low level of the neutral rate of interest. The real neutral rate of interest is often correlated to potential economic growth – when one declines it pulls down the other. This is certainly one possible explanation, but the gap between the two is currently very wide. Economists forecast potential growth of about 2 % for the US economy, vs. 3 % prior to the crisis. The consensus neutral rate of interest has fallen more, from 2.5 % to 0.5 %. There are several possible causes of this gap: demographic factors, excess savings, and slower transmission of monetary policy. The long and the short of it is that the decline in the neutral rate of inflation has not come with a similar decline in long-term growth forecasts.
The second factor is inflation expectations, which are low. This is good news for both equity prices and bond prices. That fact that inflation and wage growth remains so weak while the US economy is near full employment remains a mystery. Some possible explanations are globalisation, new technologies, the sector breakdown in job creations, and the lagging impact of the previous period of low inflation.
The third factor is that the term premium is still in negative territory, which suggests that there are few concerns over an upside surprise in either monetary policy rates or future inflation. However, let’s not overlook the fact that central banks’ quantitative easing has compressed the term premium. It is worth pointing out that, since the Federal Reserve announced plans to shrink its bond portfolio, the term premium on US Treasuries has fallen even further.
This breakdown shows that the current bond market configuration is not at odds with the equity market configuration under certain conditions, and mainly the condition that US inflation stays low. Federal Reserve members have warned that some aspects of the currently lower inflation environment are temporary. Moreover, if the Trump administration keeps its promises on tax reform and fiscal stimulus as the US economy approaches full employment, there will be a greater risk of an upside surprise on inflation.
An increase, even a slight one, in wage growth and inflation could shift bond market expectations considerably and lead to a painful repricing of risky assets, along with an appreciation in the US dollar. Moreover, under such a scenario, the Federal Reserve would at first have a hard time reacting to a financial market collapse by easing monetary policy, thus eating into the credibility of the “Yellen put”. Just imagine if the inflation that central banks were at such pains to restore were to end up posing a significant risk to financial stability.
Article published in L'AGEFI on 30/11/2017