Bond yields are a barometer of where investors think growth and inflation are going—which, for much of the last decade, has been nowhere fast. In that sense, the recent run-up in long-term interest rates that has rattled the stock market this week is good news. With both growth and inflation looking much healthier, the Federal Reserve and investors have concluded that interest rates also need to return to more normal levels.
If all goes according to plan, the stock market selloff will prove to be a temporary bout of indigestion.
The biggest factor behind the stock market turmoil is that investors are adjusting to a new era for interest rates. After the financial crisis, growth averaged a little over 2%, and inflation repeatedly fell short of the Fed’s 2% target. In response, the Fed cut interest rates to close to zero and bought long-term bonds to bring down long-term interest rates.
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By 2017, the recession’s restraining effects on risk-taking had faded, the global economy was in a synchronized upswing, and the election of Donald Trump boosted business confidence. Congress slashed taxes and oil prices climbed, fueling business investment and household spending. Growth has climbed to 3% over the past year, unemployment has fallen to a 49-year low of 3.7%, and inflation has returned to 2%.
Still, interest rates are far below historic definitions of normal. The Fed’s short-term target, at 2% to 2.25%, remains “a long way from neutral,” a level that sustains growth without fueling inflation, Fed Chairman Jerome Powell said last week.
Bond investors have belatedly reached the same conclusion, pushing yields on 10-year Treasury notes up to 3.1%. That is still 2 percentage points lower than where the current growth rate would historically predict.
When bond yields are rising toward normal, stocks tend to sink, but only temporarily, says Roberto Perli, an economist at Cornerstone Macro, an investment advisory, citing precedents in 1994, 2006, and this past February. The real problem is when stocks sell off amid falling bond yields, he said. That tends to precede recession.
Nonetheless, there are many ways things may not go according to plan: Growth may abruptly downshift as a tax-cut fueled “sugar high” recedes; tight labor markets and tariffs could push up inflation; or emerging market turmoil could spread. Any of those would threaten an expansion already looking long in the tooth.
The behavior of stock, bond and commodity markets last week showed investors’ main concern that higher oil prices would feed into inflation and interest rates, says Charles Himmelberg, chief markets economist at Goldman Sachs. This week, he saw more evidence from those markets that investors are retreating from risk and worrying about economic growth; for example, bond yields actually dropped over the last two days.
Whether this turns out to be a correction or a bear market depends mostly on how much room the economy has to grow. The current expansion is now the second oldest in U.S. history and within a year will be the longest, reason enough to question its longevity. Many conditions that preceded previous recessions are present: unemployment below 5%, a sign the economy has little unused slack; rising oil prices; and Fed tightening.
- Dollar Slips as Investors Reassess Outlook for Growth, Rates
- Analysis: Tightening in Financial Conditions Could Affect Fed Outlook
- Consumer Prices Rise 0.1%, Less Than Forecast
- Fed’s George Says Gradual Rate Rises Seem Appropriate
- Mortgage Rates Fast Approaching 5%, a Fresh Blow to Housing Market
- Heard on the Street: The Fed May Not Be Investors’ Friend
In its semiannual outlook released this week, the International Monetary Fund said the U.S. economy is already operating above its normal capacity, and the fiscal boost coming from lower taxes and increased spending “could lead to an inflation surprise,” triggering rapid rate increases, global financial turmoil, and a stronger dollar, all bad for global growth. It says Mr. Trump’s higher tariffs, in particular on Chinese imports, and resulting retaliation, could further hurt growth. J.P. Morgan estimates tariffs could temporarily boost inflation 0.2 to 0.3 percentage points next year.
One pessimistic scenario on Wall Street is that tight labor markets, higher oil prices, and tariffs all push inflation sharply above 2%, spurring the Fed to tighten more rapidly, just as the fiscal stimulus of tax cuts fades around 2020.
More optimistic analysts, though, believe the economy could have years left to run. The expansion since 2009 has been long in part because the postcrisis environment has discouraged the sorts of risk-taking and imbalances that bring on a recession, such as heavy private sector borrowing. The household saving rate hasn’t dropped much, despite a surge in wealth, cushioning consumers from a drop in property or stock prices.
And while anecdotes of labor shortages multiply, some economists see evidence there could be plenty more workers available to keep growth going. Ernie Tedeschi of the investment firm Evercore ISI says employment as a share of the population, which some argue is a more comprehensive gauge of the job market than unemployment—once adjusted for the aging population—is still lower than in 2001 or 2007.
Low unemployment may not have the inflationary impact it once did given labor’s weakened bargaining power. Both the Bank of England and the Federal Reserve have sharply reduced their estimates of the natural unemployment rate, below which inflation picks up, notes a report for the International Center for Monetary and Banking Studies by economists David Miles, Ugo Panizza, Ricardo Reis and Ángel Ubide. They argue labor markets have arrived at a “new postcrisis equilibrium, with more job creation and less wage growth.”
Widespread fears of inflation are at odds with actual inflation behavior. In September, consumer prices rose by less than economists expected for the fourth straight month. Excluding food and energy, they’re up at a 1.8% annual rate in the last three months, the Labor Department reported Thursday.
For now, the economy seems to have plenty of room to run.
Write to Greg Ip at firstname.lastname@example.org