After the US treasury 10-year yield peaked at 2.6 per cent in mid-December, US bond yields have begun retracing some of the wild moves seen post the election shock. In our view, higher treasury yields from here will require a much stronger burden of proof regarding a Trump presidency’s capability to counteract opposing structural forces weighing on long-term economic growth and inflation, in the US and globally.
As Mark Twain said, history may not repeat, but it often rhymes. Since the initial economic recovery following the financial crisis in 2008, economists – including the US Federal Reserve – have each year been forecasting a normalisation of economic growth on a six to nine-month view, which would lead naturally to higher interest rates. Every year they have ended up being disappointed that their optimism went unfounded, and their econometric modelling was seen to be clearly flawed. A normalised business cycle view has been undone by longer-term structural forces in the US and globally, which have pushed down on economic growth and interest rates.
So what evidence do we have that economic optimists may remain in a permanently disappointed state, and what are these important structural forces? If we take the US as an example, nominal economic growth (including inflation) since the financial crisis has been only 3.5 per cent per annum on average, despite real interest rates having turned negative as the US policymakers cut rates close to zero. There has been a material rise in savings versus investment, which has pushed down on global interest rates over several decades. Most economists can now agree demographics have been responsible – there has been a significant rise in retirees in the western world relative to the size of the workforce. The demographic effect certainly cannot be changed quickly – it is a multi-generational impact that inevitably will be with us for decades to come. Only higher birth rates now and greater immigration – unlikely under the current Trump administration in the US – can help to offset it over the long term.
Can the new Trump administration counteract these important structural forces that have weighed on the productive capacity of the US for the past decade and more? His team’s intention is to add to the already considerable debt pile in the US to fund significant infrastructure investment and cut taxes. In motivating the ‘animal spirits’, as recommended by the most famous of economists, John Maynard Keynes, they have certainly had the desired effect on global equity markets, which have quickly priced in higher future US growth. Leading economic indicators have also picked up somewhat of late, not just in the US. Inflation seems also set to rise further in the near term, though is still likely to remain at fairly benign levels in the context of a longer historical comparison.
Our view is that the longer-term global structural forces are unlikely to be counteracted easily by the significant expansion of fiscal policies in the US. It is likely the immediate focus on lower immigration makes the demographic imbalance even worse. Another Trump policy focus of protectionism of US industry may also be counterproductive if it leads to retaliation from countries the US would like to export to, such as China. So, we are not convinced the new Trump administration can generate significantly higher economic growth outturns over the longer term.
Some commentators currently talk about the 3 per cent 10-year yield level reached during the taper tantrum being possible again, but the Fed itself now forecast a much lower terminal Fed Funds rate of 3 per cent, from the 4 per cent rate it expected in 2013, due to some of the same structural concerns we highlighted above. Three rate hikes this year from the Federal Reserve are already reflected in current yield levels. Higher Treasury yields can also act as an automatic brake on economic momentum through higher corporate bond yields and mortgage rates, impacting on business and household spending, and forestalling anticipated rate increases from the Fed.
As we saw in 2016, bond yields can become somewhat divorced from fundamentals in any case if some unanticipated financial market/economic shocks arise. Whether it is worries over China, Brexit (again), European elections, or simply a hefty dose of realism over the new US President’s abilities, we think there is plenty of scope for downside surprises in the coming months. Volatility in bond yields is likely again in 2017, but with a balance of risks that points firmly towards much lower US Treasury yields in our view.
Craig Veysey is manager of the Sanlam Four Strategic Bond fund