VTI - Bond Market Expectations: II

2023-08-17 18:24:21 ET

Summary

• Analysts are writing about a future U.S. economy that is growing slower than before, but experiencing higher rates of inflation.
• Two big questions arise: the first is about slower real economic growth, seemingly the result of a slowdown in the growth of labor productivity.
• The second question concerns the projected future rates of inflation and the fact that the bond markets appear to be pricing in higher future rates of inflation.
• In essence, investors seem to be seeing an economic future that is not too much different from the experience of the 2010s, one with slower economic growth and a modestly higher rate of inflation.

Yesterday, I looked at bond market expectations: see " Bond Market Expectations : Slow Growth and Moderate Inflation."

In that article, I dissected bond yields to see what investors seemed to be saying about future economic growth and future inflation.

James Mackintosh, in the Wall Street Journal , has followed up with a similar analysis. It seems as if he has a similar take on current market yields.

So, let's look a little more closely at the bond market.

Mr. Mackintosh writes that things are a little more normal now.

"There was a time when the rule of thumb was that 10-year Treasury yields should be around 4.00 percent, made up of the 2.00 percent inflation target plus real yields of 2.00 percent, roughly reflecting economic growth."

Now,

"That time seems to be back, more or less, with investors pricing bonds for an inflation rate of about 2.30 percent over the next 10 years, which with a 1.89 percent real yield leaves the Treasury yield at 4.20 percent."

"That real yield is also bang in line with the consensus of Federal Reserve policymakers, who expect long-term economic growth of 1.80 percent a year."

Conclusion: this setting suggests that investors

"don't think we are going back to the post-financial crisis era of zero rates."

"Investors seem to see this as pretty much entirely good news."

Mr. Mackintosh reflects on what has happened, but asks two important questions about where we go from here.

The first question is about whether or not the economy can "return to a more normal" basis.

However, the "more normal basis" will contain higher interest rates.

The "new" normal will have the 10-year yield (US10Y) around 4.20 percent. And, this "new" normal includes a lower real rate of economic growth and a higher rate of inflation.

Remember that post-Great Recession period evolved into a "new" normal for inflation and for economic growth.

Inflation was kept quite low during the period of economic recovery between the Great Recession and the Covid-19 recession. The compound annual rate of inflation came in at around 2.2 percent. This was a very applauded result.

However, the real growth of the economy also came in at around 2.2 percent, a low rate of growth that was not liked by most analysts.

It seems as if there was a shift in the economy, in this period from before the Great Recession.

As I have reported in many posts, it appears as if government policy resulted in more and more money going into the financial circuit of the economy, with fewer dollars going into real investment that upped labor productivity.

In fact, we saw that during the 2010s, the growth in labor productivity fell and, as a result, real economic growth slowed.

The 2010s saw the U.S. economy growing strongly and steadily but at a slower rate than during earlier periods of economic expansion.

The economy was growing but was experiencing supply-side issues that resulted in a slower economic expansion.

Now, it appears as if investors are taking this result one step further.

Are investors expecting that the supply-side issues of the 2010s will carry over into the 2020s and, as a result, the U.S. economy will grow at an even slower rate than it did in the previous decade?

Mr. Mackintosh suggests that these changes will require only a minor restructuring of the economy.

I hope that he is correct in this assessment.

The second question relates to this. It is the concern about whether or not the changes will result in a more inflationary economy.

Mr. Mackintosh claims that:

"If the economy has become permanently more inflationary even than it was in the 2000s, then the Fed will have to run with higher real rates to hit its target."

Again, this is not something we should hope for.

Conclusion

As a reader commented on my earlier review of the bond market,

"the market's inflation expectations are often wildly inaccurate…"

It is true that "the market's inflation expectations are often wildly inaccurate…"

But, that is not the issue. The issue is to try to understand why the market is where it is and where the market might be going.

The analysis performed above therefore can be helpful is discerning what is happening and why.

The fact that the bond market has now returned to a level that is "more normal" and not in a place never seen before is important for us to judge.

Also, we need to assess whether or not "the market" will remain at this "more normal" level.

We are not, by any means, stationary in this "more normal" world.

The current market situation could crash and fall apart very quickly, from where it currently resides.

But, that is another narrative.

Right now, it looks as if the Federal Reserve and the bond market are working toward a more "stable" situation.

This more stable situation, I believe, will result in a continued slowdown in the growth of labor productivity, a continued moderation in real economic growth, and a slightly higher rate of inflation over the next decade… especially with the U.S. debt situation out of control.

But, we are in a world of radical uncertainty. We don't know all the factors that may impact our future.

We can only continue to keep our analysis as real and as complete as we can.

For further details see: