US bond bears are right, but for all the wrong reasons


With the yield on 10-year US Treasury bonds rising to a seven year peak of nearly 3.25%, many bond market bears will be feeling a sense of belated vindication. But the story behind rising long-term interest rates has little to do their preferred script.

Forecasts of rising interest rates have been a staple of year-ahead investment outlooks for many years. The macro story underlying these forecasts goes something like this.

Years of ‘easy’ monetary policy finally leads to an outbreak of inflation.

The Federal Reserve responds by raising the Fed funds rate. Reflecting expectations of rising short-term interest rates, long term interest rates rise in sympathy.

The bond market bear then becomes a threat to asset prices and the real economy.

After numerous false starts, including a premature Fed tightening at the end of 2015 that was not followed-up until a year later, the bond bears finally appear to be getting their way.

The Fed has managed three rate increases this year on top of three in 2017. But real interest rates are not rising because of the Fed. The real Fed funds rate is still barely positive.

US interest rates are not rising because of inflation fears either. Adjusting interest rates for inflation implies that it is real yields that are rising on the back of a strong US economy. That’s good news, not bad.

Actual and expected inflation remain remarkably subdued. The overall personal consumption expenditure (PCE) inflation rate for August was just 1.3% annualised, while the PCE excluding food and energy measure rose only 0.4%.

The break-even inflation rate implied by US 10-year inflation protected securities has trended side-ways this year and remains below the levels seen in April and May at just above 2%.

All of the movement has been in real interest rates, with the US 10-year yield adjusted for inflation rising above 1.00% for the first time since 2011.

Rising real interest rates are not a surprise given the current strength of the US economy. What is surprising, at least to some, is the lack of inflationary pressure flowing from that strength.

Many analysts expected inflation pressures would also arise from US President Donald Trump’s tax cuts.

But this underestimates two factors. First, the tax cuts are positive for the supply-side of the US economy, increasing its productive potential.

Second, to the extent that the productive potential of the US economy does not accommodate the associated increase in domestic demand, the US dollar exchange rate will tend to appreciate, relieving the Fed of some of the burden of tightening overall monetary conditions.

With inflation and inflation expectations remaining subdued because, and not in spite of, an expanding real economy, the Fed has been sidelined relative to previous expansions.

This is good news for the durability of current expansion, already one of the longest on record. As the economist Rudi Dornbusch said in 1997, ‘none of the U.S. expansions of the past 40 years died in bed of old age; every one was murdered by the Federal Reserve.’

The Fed has few excuses for making the same mistake on this occasion, although the flattening of the US yield curve to its lowest since 2007 points to this risk.

The rise in US yields has seen the spread between Australian and US long-term interest rates invert to its lowest level on record.

Australian long-term interest rates have lagged their US counterparts in such as unprecedented way in part because inflation expectations implied by Australian 10-year inflation-indexed bonds have been stuck around 2%, below the Reserve Bank’s desired average for inflation of 2.5%.

Financial markets can be forgiven for thinking the RBA will not hit the middle of its 2-3% medium-term target range any time soon. The RBA doesn’t believe it will either.

Inflation has been below the mid-point of the target range since the December quarter 2014. On the RBA’s own forecasts, inflation is not expected to return to the middle of the target range over the next two years.

The official cash rate has been left unchanged since August 2016, the longest period of steady policy rates on record.

The Reserve Bank blames low inflation on slow wages growth, claiming in a recent Statement on Monetary Policy that ‘labour costs are a key driver of inflationary pressure,’ but this is to put the cart before the horse.

In fact, recently published research shows that it is low inflation expectations that are largely to blame for low wages growth.

It is inflation expectations that drive both inflation and nominal wages and these expectations are in turn driven by perceptions of the stance of monetary policy.

Over to you Phil Lowe.

Dr Stephen Kirchner is Program Director of Trade and Investment at the United States Studies Centre at the University of Sydney.