Aside from the equity market, reactions in the US bond market have also raised investors’ eyebrows. In particular, the 10-year US Treasury bond yield has broken its resistance level of 2.6 percent in January 2018, touching 2.9 percent in recent times – the highest since early January 2014. The sudden yield surge is attributed to a number of reasons, one of which is the state of the US economy, which continues to strengthen. Indeed, growth is likely to accelerate further to circa 2.5 percent, if not higher, in 2018. This growth has been supported by strong consumer spending, which is premised on solid labour market fundamentals. The jobless rate at 4.1 percent is below the so-called ‘non-accelerating inflation rate of unemployment’ (NAIRU), helping fuel private consumption that grew at an annualised pace of almost 4 percent in the final quarter of 2017. That was the strongest expansion since the fourth quarter of 2014. Capital spending is also rebounding amidst a sustained recovery in industrial capacity utilisation. This, in turn, will solidify the strength of the US economy going forward.
Notwithstanding the above, the bond market could still be underestimating the Fed’s future policy response to the US’ strengthening growth momentum. This increasing upward momentum of the economy is due to several reasons. Firstly, while this is commonly discussed, the market may not have fully priced in the full impact of President Trump’s tax cuts on the US economy. The general view is that it will be mild, at best. However, as the late Nobel Prize economist Milton Friedman used to argue, the impact of policy interventions tends to hit at the wrong time in the business cycle, causing the economy to overshoot. According to him, monetary policies that try to smooth out the business cycle would actually end up making it worse. For instance, in the US’ current context, the impact of the tax cuts will be keenly felt when the economy is already robust and fully recovered from the global financial crisis. Hence, such a policy will amplify the strength of the already-solid economy and could lead to an economic overheating in the near future.
Secondly, the declining strength of the US Dollar (USD) could add to the headline growth in 2018, thereby strengthening the economy even further. This is evidenced by past statistics: when the US real effective exchange rate (REER, i.e. exchange rate against a basket of major currencies and adjusted to inflation) strengthened between mid-2014 and the first quarter of 2016, the country’s net export contributions to real GDP growth turned negative between the fourth quarter of 2014 and the first quarter of 2016. But when the REER started to depreciate from the final quarter of 2016 throughout 2017, net export contributions to real GDP growth in the US turned positive in the first three quarters of 2017. As such, if the current weakness in the USD prevails in the near term, positive net trade effects could add to the economy’s headline growth in 2018.
Another sign of a possible surprise on the upside in the US economy is related to what is known as ‘term premium’. Term premium is essentially the difference between the yield of long-term securities (e.g. 10-year US Treasury bonds) and the expected returns of short-term securities (e.g. the one-year Treasury Bill) over the period. Numerous studies by the Fed in recent times tended to support the view that declining long-term US interest rates can be significantly explained by the fall in the term premium. This conclusion was even reported at Congress by former Fed Chairman Alan Greenspan in 2005. In addition, recent studies by the Fed on the term premium suggested that a decline in the term premium tends to be followed by faster GDP growth. The finding is, in fact, in line with the intuition expressed by another former Fed Chairman, Ben Bernanke, when he suggested that a decline in the term premium actually signalled additional stimulus to the economy.
What it all boils down to is this: since the term premium has continued to decline and has recently fallen into negative territory, there is now a possibility that we could see stronger US GDP growth in the near term. And with all these upside growth surprises, it is conceivable that the Fed would step on its rate-hike accelerator further and spark a run-up in bond yields. This could lead to a significant correction in the bond market – a scenario that might not have been fully priced in by the financial market.
Another critical issue that often pops up during discussions on Fed actions that could impact the bond market is inflation expectation. It is a well-known fact that the Fed wants to see stronger inflation numbers before changing the tempo of its rate hikes. In this regard, inflation expectation has remained stubbornly low. However, according to some economists, low inflation numbers are the result of import and commodity price weaknesses, which will dissipate as the global output gap narrows. Hence, the inflation genie will likely spring out of the bottle again soon and induce central banks to speed up their monetary normalisation processes.
All in all, this would mean that despite favourable macro prospects in 2018, surprises in both the equity and bond markets cannot be ruled out. And although the financial market has generally been resilient in the past few years, current macroeconomic and market conditions suggest that the fear of pronounced corrections in both the equity and bond markets is already gaining traction.