“Waiting too long to begin moving toward the neutral rate could
risk a nasty surprise down the road – either too much inflation,
financial instability, or both.”
—Federal Reserve Chair Janet Yellen,
18 January 2017
When there is fear of inflation on the streets of the bond market, a cop
needs to walk the beat; otherwise, bond investors take matters into their
own hands. Without proper policing from the Federal Reserve, bond investors
typically begin demanding higher interest rates to compensate them for the
risk that inflation will accelerate and that the acceleration will
eventually force the Federal Reserve to raise interest rates more than
This is one reason why bond yields have climbed of late: Many investors
worry the Trump administration will take actions to promote faster U.S.
economic growth at a time when, as Fed Chair Yellen recently said, it isn’t
obvious that fiscal measures are needed to reduce the jobless rate further
from an already low 4.8%. More downward pressure on the unemployment rate
could boost wages, strain employers’ resources and stoke inflation (Figure
Fear of faster inflation is why a hawkish Fed – a Fed that warns it may
increase its policy rate more than markets expect in the near term
– can ultimately be good for the bond market. A hawkish Fed can
calm fears of economic overheating and thereby steer bond investors’ views
on the long-term path for the Fed’s policy rate, the
federal funds rate.
Judging by current market levels, investors today see the fed funds rate
rising to around 2% by 2020, well below the peaks of 5.25%, 6.5% and 6.0%
for the rate-hike cycles that ended in 2006, 2000 and 1995, respectively.
In this vein, we think the Fed’s mantra should be “protect the path” ‒
protect the current view that its policy rate will stay low for the rest of
the decade and beyond ‒ to minimize the risk of financial instability that
much higher market interest rates could potentially bring.
In contrast, if the Fed takes a dovish stance now despite signs that the
U.S. has reached full employment, and is therefore slow to shift its focus
toward the inflation side of its dual mandate, this could ultimately be bad for the bond market; bond market “vigilantes” would likely
push market rates higher, creating volatility. Only when the Fed returns to
the beat and engages the bond market’s nemesis – inflation ‒ will the
The Fed has successfully contained inflation fears in the past by taking a
hawkish stance. For example, in November 1994 the Fed, then under the
leadership of Alan Greenspan, moved decisively to address inflation fears
by announcing a whopping 75-basis-point rate hike, which sparked a big rally in the bond market, taking many by surprise. A little tough
love can go a long way in the bond market.
Yellen’s Costanza moment
In a famous episode of the popular U.S. television series “Seinfeld,” the
hapless character George Costanza finds that by doing the opposite
of what he ordinarily does, he actually gets what he wants.
For the Fed to get what it wants – maximum employment alongside price
stability – it could do the opposite of what it has typically done during
the post-crisis period to temper the bond market’s view of how high the
federal funds rate will go.
Specifically, in recent years, the Fed has repeatedly reassured investors
that rates would stay low for some time – a dovish stance at a time when
more hawkish talk and actions would have been detrimental to markets and
the struggling economy. Today, a more hawkish approach may be warranted.
Alternatively, if the Fed’s focus does not shift to taming inflation, bond
market vigilantes will likely look to drive yields higher, effectively
tightening policy for the Fed and arresting inflation on their own, but
also creating uncertainty over the future path for interest rates.
Bond market volatility: taking the long-term view
Arguably, the biggest investment implication of the recent U.S. election
will be a likely pivot away from central bank dominance to fiscal
dominance. As the task of promoting economic growth shifts from the Fed to
U.S. fiscal authorities, an upward bias is likely in U.S. economic growth,
inflation and bond yields.
Already, the bond market has experienced a “Trumponomics Tantrum,” with the
U.S. 10-year Treasury yield moving to about 2.6% from 1.85% since the
election (Figure 2).
Rising Treasury yields also currently reflect uncertainty about the degree of change to the outlook. Investors are reintroducing risk
premiums into the bond market – the extra yield that compensates them for
uncertainty. Risk premiums have been very low for years, in part due to the
dysfunction in Washington that made the Fed the only game in town.
What’s next for U.S. Treasuries and the bond market more broadly?
The answer lies in whether the government is able to permanently
alter the U.S. growth trajectory. To do so, the U.S. must overcome
headwinds from demographics and indebtedness and bolster the sagging growth
rate in U.S. productivity, which is the defining indicator of changes to
the nation’s standard of living. This is a big undertaking, requiring a
focus on the long-term drivers of growth, such as education and
investment. Only if productivity improves will bond yields move appreciably
and sustainably higher. For now, markets are appropriately skeptical,
priced for the Fed’s policy rate to end the decade at around just 2%.
Investors should therefore focus on the quality of forthcoming
fiscal endeavors. For example, will the U.S. choose the big, bold projects
such as the Dwight D. Eisenhower Interstate Highway System, which produced
some 50,000 miles of roadway that Americans still benefit from today
(Figure 3), or will it choose low value-added projects similar to those
that were crafted for the American Recovery and Reinvestment Act of 2009?
For now, we think a “show me” mindset is warranted.
Trumponomics alone will likely not be enough to sustain a significant
increase in yields, owing to deep structural influences at play in not just
the U.S. but the rest of the world, which will limit the extent to which
the Fed can raise rates.
We think global influences will bias yields downward for the rest of the decade, in particular the Bank of Japan’s promise to
keep Japan’s 10-year bond yield capped at around 0%, as well as zero or
near-zero policy rates in Europe. Other major global yield suppressors
include powerful and irreversible demographic influences, weak global money
creation, cautious consumer behavior and China’s transition to a
consumer-led economy, which will take time and limit new vigor in the
The New Normal is still valid
While the potential for fiscal stimulus points to a relatively strong
cyclical outlook for the U.S., in order for it to last the U.S. must
address deep-rooted domestic factors that are stymieing growth in
productivity, in particular weak growth in investment in people and in
“stuff” ‒ plants, equipment, software, structures and infrastructure.
Capital investment is one of the three major sources of productivity, along
with human capital and how people use their skills and the nation’s capital
stock to produce goods and services.
Capital intensity, which measures the amount of capital in place
per unit of labor, fell year-over-year last year for the first time since
at least 1953 (Figure 4). This decline is akin to a company with 100
employees and 50 computers one year ago having 100 people and 48 computers
today ‒ clearly a negative development for productivity and growth.
It is notable that Yellen, in
a speech in Wyoming on 26 August, said faster U.S. productivity growth would “raise the average level of
interest rates.” Therein lies perhaps the biggest key to the long-term
outlook on U.S. rates. Yellen knows, as bond investors do, that faster
productivity results in faster income growth and higher levels of aggregate
spending, which can boost inflation and interest rates.
Attaining faster productivity in the U.S. will be no small task given the
nation’s high level of indebtedness, its rapidly growing entitlements
obligations and the political difficulties of channeling the nation’s
resources into endeavors whose benefits will in some cases extend beyond
the political lives of those in power.
For many reasons, then, it is fair to say that the New Normal for
economic growth – the era of slower-than-historical growth – remains
Therefore, the bond market’s current benign outlook for the Fed’s policy
rate is rational.
In sum, the rate outlook will not change much unless one of three things
happens. First, the Fed would have to fail to shift its focus to inflation
in a timely manner, altering the bond market’s benign outlook on the path
for the fed funds rate. Second, the bond market would need to be convinced
that fiscal initiatives will cause a permanent change in the U.S. growth trajectory. The third
would be a change in the outlook for global policy rates, which is
In this uncertain time, we think portfolio diversification is crucial and
caution against trying to time the vacillations in the bond market when
aiming to achieve it. Investors may want to think long term and welcome the rise in yields, which over the long run should boost
returns, and take advantage of market volatility when prices deviate from