Forget secular stagnation, Jan von Gerich the bond market is pricing in secular stagflation Nordea Research, 21 February 2017

Everybody seems to be talking about secular stagnation, or the prospect of low or no growth for the foreseeable future. However, what the bond market is currently pricing in is even more frightening: inflation without growth.

Does the recent rise in yields really signal expectations of a brighter future?

The current low level of nominal interest rates is often taken as a testament that the bond market has lost all hope that the economy would ever rebound. Correspondingly, the recent rise in US bond yields, partly driven by the election of Donald Trump, is generally seen as signalling increased confidence of faster economic growth.

This is by far not the whole story. While there are many factors driving the level of long yields, which is ultimately determined by the laws of supply and demand, the economic interpretation of long nominal interest rates is that their level illustrates expectations of real economic growth added with inflation. As a result, higher rates usually indicate brighter growth prospects and vice versa. However, merely looking at nominal rates makes it impossible to conclude, whether higher rates are driven by higher inflation or real growth expectations.

A decomposition of long nominal yields into so called real yields and inflation expectations gives a better picture of what the bond market is actually pricing in. Such decomposition reveals some startling findings.

First, the level of long nominal yields is mostly accounted for by inflation expectations, while real yields are low or even negative. Second, the rise in nominal yields has been driven by higher inflation expectation, not so much by higher real yields.

The current level of nominal yields explained almost fully by inflation expectations nexus.nordea.com/research Current real yields illustrate more than just weak growth prospects…

Real yields are what drive the economy and are a major determinant of how easy monetary policy is. From that perspective, the current low real yields can be seen as welcome in trying to bring life into the economy. Apart from weak economic performance, the low real yields illustrate the exceptional central bank stimulus measures, including the massive bond purchase programmes.

…but the picture longer out very grim

However, the outlook appears much gloomier, when one looks at how the bond market expects real yields to develop going forward.

In the US, the 5-year real yield is priced to top at just above 0.5% in the 2030s and start to fall again after that. The economic interpretation of this is that the bond market does not expect US real growth to be much higher than 0.5% annually on average over any 5-year period going forward. Even in the past 10 years, which incorporates the Great Recession, average annual growth has been around 1.3%.

The picture for the Euro area is even gloomier. Forward 5-year EUR real rates reach their highs of -0.10% in the 2020s and start to fall again longer out – in other words, an outlook of no economic growth whatsoever. By comparison, the past 10 years has seen growth average some 0.8% despite the financial crisis and the sovereign debt crisis. nexus.nordea.com/research Long real forward rates do not illustrate really any growth expectations

It gets worse – the market is pricing in inflation without growth

Could the market just be pricing in a scenario, where the central banks are forced to continue ultra-easy monetary policy and keep real yields at artificially low levels over an extended period of time in a desperate attempt to try to lift inflation towards the target? The pricing of inflation expectations overrules such interpretation.

Implied 5-year US inflation expectations are expected to be close to 2.5% over the next 25 years. Even in the Euro area, implied 5-year inflation expectations rise above 2% in around ten years’ time and stay there. Central banks are thus expected to reach their inflation targets, and should not have a reason to continue exceptionally accommodative monetary policies.

The inflation picture is priced to normalize

nexus.nordea.com/research In conclusion, the bond market is pricing in a scenario of very low or no growth even in the longer run – something one might call secular stagnation. However, as the market is pricing in inflation at the same time, secular stagflation is a more appropriate term, an even grimmer prospect.

President Trump has not done really anything to change that picture. The bond market pricing illustrates that what the economy really needs is longer-term reforms to lift production capacity. The US economy certainly does not need short-term fiscal stimulus to push inflation expectations even higher.

nexus.nordea.com/research

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