The “new normal” is beginning to look a lot like the old normal.
Bond yields have climbed decisively in the last six weeks, with the yield on 10-year U.S. treasuries topping 2.8% for the first time since mid-2014—about half a percentage point above last year’s average. Stock markets experienced a sharp correction followed by a robust rebound—much greater volatility than we had seen in a while.
It took just a minor uptick in wage growth data to trigger these financial shockwaves: average hourly earnings rose to 2.9% year-over-year in January from December’s 2.7%.
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Financial markets are beginning to lose faith in the reassuring narrative of the last several years. In the aftermath of the global financial crisis, the Fed and other major central banks injected enormous amounts of liquidity into financial markets. This extraordinary monetary expansion was fully justified as an immediate emergency response, but central banks kept it going well after the recovery had become entrenched.
A majority of commentators argued that persistent risks of recession and deflation warranted the expansionary monetary stance. Prominent economists and investors went further: They posited that the U.S. and other advanced economies had entered a “new normal” of weaker growth and very low inflation, and that interest rates would therefore remain extremely low for the foreseeable future. This consensus view became baked into market expectations of interest rates.
For an extended period, investors complained about mediocre economic growth prospects while enjoying stellar returns on financial investments. This apparent contradiction worked in fact as a self-reinforcing cycle: Pessimism on growth cemented the belief that asset prices would benefit from loose monetary policy for the foreseeable future; and it reassured central bankers that the eventual policy normalization would be limited in scope and could be carried out at leisure.
The weak-growth narrative has now collapsed. U.S. business confidence held at record-high levels through 2017, and received a further boost from tax reform and less visible but equally important progress on deregulation. The global economy is enjoying the broadest synchronized upswing since 2010, according to the IMF, with robust momentum across both advanced and emerging economies.
Risks to the interest rate outlook now appear dangerously skewed to the upside. Over the coming quarters, GDP growth will likely beat expectations. If wage growth maintains the accelerating trend of the last few months, the Fed will look far behind the curve, and investors will need to price in a more aggressive pace of rate hikes. Meanwhile, government bond markets will experience a substantial rebalancing of demand and supply: Over the past two years, major central banks absorbed more than the entire issuance of G-10 government bonds. Now the Fed has begun to unwind its balance sheet, and the ECB is scaling back its pace of asset purchases. With the U.S. fiscal deficit set to rise, and central bank purchases declining, yields have a lot further to rise.
In the equity market, rising interest rates will be cushioned by a better growth and profits outlook. But outstanding debt of the U.S. non-financial corporate sector has increased from about 40% of GDP in 2010 to over 45% in Q3 2017. Parts of the corporate sector will come under stress if funding costs rise faster than expected, bringing additional volatility. Expect greater volatility in FX markets as well. Dollar weakness will not last as yield differentials in favor of U.S. assets widen and the U.S. economy picks up pace.
The last several years have been dominated by massive central banks’ interventions in asset markets and a widespread but misguided conviction that advanced economies would be forever mired in a low-growth, low-interest rates environment. Both are now over.
Central banks will normalize policy gradually and carefully. The financial sector no longer suffers from the reckless leverage of 2006. But reversing 10 years of massive quantitative easing and zero/negative interest rates is an unprecedented experiment. It would be folly to assume they can pull it off smoothly, without shocks or accidents. Yes, central banks have successfully cushioned the recession. But in the monetary expansion phase they could wield the sledgehammer, shocking financial markets with massive liquidity injections. The tightening phase needs to be finely calibrated, carefully managing market expectations. That’s a lot harder.
The new normal will look a lot like the old normal. But getting there will be a bumpy ride.
Marco Annunziata is co-founder of Annunziata + Desai Advisors, and the former Chief Economist and Head of Business Innovation Strategy at GE.