Can Fed turn bonds yields at Jackson Hole? (3 min read)
Bond yields across the world are falling to record lows. US 30 year treasury yields are at their all-time lows and flirting with the 2% threshold, German 10-year government yields have crossed below -0.6%, and remarkably, Spanish 10y yields are close to zero percent. Nervousness around China – whether based upon the Hong Kong protests or weak economic data – appears to be impacting yields. Worryingly, not even President Trump’s recent, more conciliatory trade comments have been able to arrest the decline in yields. The ball is therefore firmly in the Fed’s court to introduce a new dynamic for bond yields, and so the upcoming annual gathering of Fed officials on 22-24 August at Jackson Hole will take added importance.
Of course, the drop in yields could simply reflect the business cycle, which has taken a decided turn for worst especially in the manufacturing sector (Chart 1). The Fed must consider how much they can turn the sector around, especially given the dominant impact of US trade policy. Admittedly, the Fed has cited ‘global developments ’ as a reason for cutting rates at their last meeting, so further insurance cuts would not be out of the question.
The deeper question and one that the Fed will probably be addressed at Jackson Hole is whether the neutral real rate (r*) for the US has fallen even further. Fed Chair Powell recently noted that ‘Standard estimates of the neutral rate of interest—r*—have been declining for 2 decades, and particularly since the crisis.’
He believes many factors are contributing to these changes: ‘well-anchored inflation expectations in the context of improved monetary policy, demographics, globalization, slower productivity growth, greater demand for safe assets, and weaker links between unemployment and inflation’.
Meanwhile, the Fed has been steadily cutting its official estimate of r* since publishing its forecasts in 2012 – from 2.25% to 0.5% most recently. We can extract a market estimate of real r* by looking at the nominal and inflation curves in the US. Doing so, we find that the market implied r* is now in negative territory at -0.35% (Chart 2). If the Fed follows the market lower in its estimate, then this would imply that current monetary policy is tighter than before – at least in the Fed’s eyes. This could be another justification for the Fed to ease policy outside of shorter-term cyclical issues.
The bottom line
Either way, bond yields are likely to continue to drop unless the Fed asserts a more dovish tone. The challenge for them is to find a credible way to communicate such a shift. A wonkish approach of lowering its r* estimate or even restating its willingness to allow inflation overshoots could be one route. The other would be to cite global issues once again. We’ll find out next week at Jackson Hole.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)
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