With Idahoans worried about trade wars, here’s what the markets think about growth | Opinion
Who are you going to believe? When it comes to the economy, investors are unsure whether to listen to the Fed or to the president. But the current talk from both is just confusing the market, forcing many investors to look for low-risk, liquid investments.
Last month, Federal Reserve policymakers lowered their benchmark interest rate, citing an “uncertain” outlook for the economy. They likely have concerns with international trade policy going forward. The president has threatened tariffs on just about all our trading partners. The trade rhetoric increases uncertainty and volatility in the bond and currency markets, which is likely to spill over to the stock market. Let’s consider the bond market first.
Expectations for the economy can be measured in the bond market using the Treasury yield curve — a graphical representation of the relationship between interest rates on US government debt with different terms to maturity. The yield on debt moves inversely with prices — when investors sell bonds yields rise and vice versa.
When the entire yield curve moves upward for all maturities it indicates investors are selling out of bonds overall and moving capital to riskier assets, which has been the trend for nearly four years. This action occurs whenever investors expect economic growth to improve, resulting in higher profitability for stocks and other risky assets.
During 2024 the entire line shifted relatively little. The yield on short-term debt has fallen, but long-term yields are pretty much the same. What changed this past year is the shape of the line. The shape of the yield curve — upward sloping (higher long-term rates) or downward sloping (lower long-term rates) — depends on factors beyond just economic growth. These factors can be classified into two general categories — inflation expectations and/or liquidity concerns. Expectations for future inflation, and as a result future interest rates, are influenced by bond investors today. Since the current yield curve is flat, or just lightly sloping upward, bond investors are saying they expect interest rates will be the same in the future. The curve has flattened in response to investors selling short-term bonds and buying long-term bonds to capture the high current rates.
If the economic outlook were better, the yield curve would be steeper. When the economy is expected to expand bond investors expect higher prices for goods and services, that is, inflation. They then sell current long-term bonds and buy short-term bonds, respectively raising and lowering the yields on each.
Another factor that can affect both the shape of the yield curve and its height is called the liquidity premium. When the preference for short-term debt becomes greater, investors sell current long-term securities and buy short-term securities, respectively raising and lowering the yields on each.
Combining the observation that the entire yield curve has moved little and noting that the slope of this line has flattened, suggests that the second factor, liquidity concerns, is the driving force today. The outlook for economic growth is relatively low and there is little expectation that price pressures will increase, so investors simply want to hold on to very liquid government bonds at all maturities.
The currency market is sending the same signal – liquidity matters.
Over the past year, the value of the US dollar has risen approximately 11% relative to the rest of the world. Looking back over the last decade, the dollar is 30% higher. This so-called “strong” dollar has the president and others claiming that foreign governments are manipulating the value of their currencies to gain an export advantage against the United States.
The argument here is that other central banks around the world are purposely keeping short-term interest rates lower than rates in the US so that investors will sell their currency and lower its value, making exports from that country more price competitive.
The strength of the dollar, however, is more about investors’ expectations for the return on risky assets than currency manipulation. The economic outlook outside the United States is simply weaker.
The European Central Bank, the Bank of Japan, and others have kept rates lower to stimulate spending and investment in their domestic market, which can sometimes have the effect of lowering the value of their currencies. But there is no evidence that central banks are making large purchases or sales of their own currencies to push values lower against the dollar. Again, bond markets reflect the diverging economic outlook. Yields in the global bond markets are nearly 2% less than those in the US. The spread between 10-year US Treasuries and yields in Japan is over 3%.
Economist Irving Fisher first formulated and explained how these differences arise – real returns or inflation expectations. Fisher showed that the yield on one country’s bonds will be higher than another’s if either inflation is expected to be higher or the real, inflation-adjusted return is expected to be greater. Since yields are similar across all maturities it again must be the “real return” that is expected to be different, not inflation. The risk of holding long-term assets without a government guarantee is just too high. Better to keep my capital liquid.
For the average investor, this situation calls for patience and global diversification. Individual investors, and even professional money managers, should not try to “play the yield spread” in the bond market, or try to beat the highly volatile and competitive currency market.
It may be hard to believe Fed policymakers and the president. So don’t call them. Just listen to the markets themselves and stick to your long-term investment plan.