There is a convincing counterargument to the belief the U.S. will experience runaway economic growth and corresponding inflation and higher interest rates.
Instead, it may be highly likely that, like Japan and the Eurozone before it, and after pandemic stimulus wanes, the U.S. may be stuck in a low growth, near zero interest rate policy (ZIRP) for an extended period.
That excess savings, an ageing population and other factors are conspiring to leave the Federal Reserve resigned to ZIRP.
Here are a few excerpts and charts from an excellent report by Alpine Macro.
by Chen Zhao, Founding Partner, Chief Global Strategist, Alpine Macro
Policymakers are not as good as markets in sniffing out secular changes with enormous long-term consequences.
For example, it took a long time in the 2000s for the Bank of Japan (BoJ) to discover that it could not end its zero-interest-rate policy (ZIRP), with the central bank finding that out the hard way:
Every time it tried to bump up rates, the yield curve flattened, stocks tumbled, and the economy fell back into a recession.
Similarly, back in 2011, the European Central Bank (ECB) discovered the new equilibrium rate by mistakenly pushing up rates from zero at a time of a brewing sovereign debt crisis.
Such an action caused stocks to collapse, plunging all of Southern Europe into a massive debt crisis that almost destroyed the euro. Policymakers were forced to drive rates to zero in 2012.
An Eerie Historical Parallel
With ZIRP becoming a permanent policy feature for both the BoJ and the ECB, a natural question is whether the Federal Reserve will ever be able to raise rates above zero again.
The majority of Federal Open Market Committee members say they can and believe 2.5% is the resting spot for the fed funds rate.
Not surprisingly, 7 out of 18 FOMC members want to pump up rates as early as 2022, especially given the current economic boom and elevated inflation levels.
Maybe these hawks are right, but we are not convinced. Last week we laid out why the recovery boom will be temporary and the recent spike in inflation may have already peaked out.
Regardless of these short-term considerations, there is an eerie historical pattern, or parallel, that we should all pay attention to, which is this:
In recent history, major financial and economic crises have all become the catalysts to bring short rates down to zero permanently.
For example, it was the 1998 Asian financial crisis that brought about ZIRP for Japan (Chart 1).
Similarly, it was the 2008 Global Financial Crisis and 2011 eurozone debt crisis that drove rates down to zero in the eurozone.
With the Covid-19-pandemic-inspired recession having driven policy rates to zero again in the U.S., could the Fed face a similar situation today as the BoJ did in the early 2000s or the ECB in the 2010s?
The answer is possibly.
Growth Versus Rates
There are many explanations on why rates can fall to zero.
Some believe that low interest rates reflect economic stagnation, while others blame zero rates on an over-indebted economy.
Whatever the true reasons, the basic assumption is that interest rates should more or less key off nominal economic growth.
Chart 2 shows long-term interest rates, measured as 10-year bond yields, and nominal GDP growth in the U.S.
Although interest rates and nominal growth are correlated, the relationship is complex and not entirely consistent over a long period.
Are low bond yields an aberration or a sign of prevailing excess savings? Many developments suggest it is the latter.
- First, investment has fallen short of domestic savings since 2008, which has coincided with the structural downshift in both the long and short ends of the curve (Chart 6).
The Covid-19 pandemic has worsened the excess savings problem, with household savings soaring but corporate investment having only experienced a feeble rebound.
- Second, the real bond yield, measured as the 10-year Treasury Inflation protected Securities (TIPS) yield, has plunged since the Covid-19 pandemic, even though the U.S. government has massively ramped up fiscal stimulus (Chart 7).
The bond market is saying that the aggregate demand generated by the fiscal stimulus has fallen far short of the net increase in private sector savings.
Finally, although the U.S. fiscal deficit has shot up astronomically, the U.S. current account deficit has only increased by a very small amount, suggesting that a wall of domestic savings has largely financed the U.S. public sector borrowing.
The key difference between the U.S. and Europe/Japan is that the U.S. government has turned hyper aggressive in providing fiscal stimulus.
However, whether it will win the war is still unclear at all. So far, the TIPS market is saying that fiscal activism is not sufficient and rates need to stay at zero, possibly for the foreseeable future.
There is a non-trivial probability that the natural rate of interest in the U.S. has already fallen below zero and if so, the Fed may not be able to raise rates by much, if at all, from the zero bound.
The pandemic crisis might have been the needed shock to reveal the new equilibrium interest rate. The broad demographic backdrop is unambiguously supportive for bonds.
However, it also means that any attempt by the Fed to raise rates will be bad news for stocks. Last time, stocks ran into problems when the Fed pushed up rates to 1.50% (Chart 13).
Should the Fed raise rates in the future, the choke point for stocks should be much lower. The Fed can control the short end of the curve, but not long-term bond yields.
In all likelihood, the fiscal impulse for the U.S. economy will turn negative starting from the end of September when the fiscal support ends.
This is another reason we have taken a constructive view on U.S. Treasury bonds.
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