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The worst market call of 2014 has, so far at least, been the virtual assumption that interest rates will rise. Indeed it was just over a year ago that rates rose sharply due to Chairman Bernanke’s hint that the Fed would begin “tapering” – reducing stimulus – in view of a strengthening U.S. recovery. As the prospects for recovery have waned (first quarter GDP was just reported at minus 1 percent, the weakest since first quarter 2011’s minus 1.3 percent pace), interest rates have plunged. The yield on 10-year treasuries has dropped from a 3 percent 2013 high, driven in the months following the taper scare by expectations of faster growth and higher inflation, to 2.44 percent yesterday. As the Fed has begun to taper, growth and inflation have both fallen, obviously not the desired outcome.
Expressing “surprise” about falling interest rates, given weakening GDP growth, is like being surprised at feeling faint after having bled profusely for an hour. Major analysts at JP Morgan, Morgan Stanley, and Goldman Sachs, to mention only the most prominent, are “surprised” at falling interest rates because the rates do not fit with the assumption that 2014 growth will rise to a 3.5 percent pace. First quarter 2014 growth forecasts, which started at 3.5 percent and held at 2 percent right up until the release of last month’s report, were strikingly higher than the actual estimates which came in last month at 0.1 percent and revised down to minus 1 percent today.
After this dismaying lack of prescience, most forecasters are sticking to the growth rebound story. Goldman, for example has boosted their second quarter growth forecast to 3.9 percent, partly due to the large inventory sell off reported for Q1. Producers are supposed to be eager to boost inventory investment to meet strong demand during the “second half recovery,” a recovery which has been predicted annually since 2009. Indeed it was that recovery prospect that prompted Chairman Bernanke to offer his counterproductive hint about tapering a year ago.
Growth will probably pick up to about a 2 percent pace during Q2. It may rise by more, but negative 1 percent growth in Q1 requires at least a 5 percent Q2 growth pace to produce the 5-year average growth pace of 2 percent during the first half of 2014. Some are predicting this extreme outcome that, exciting as it would be, would only return first half 2014 growth to a 2 percent trend pace.
But I would not bet on it. An absence of wealth gains on stocks and homes – that have been adding a percentage point to growth since 2010 – will weaken consumption, the major source of U.S. growth. Investment is weak, fiscal policy is in neutral, net exports are weak. The only chance for growth comes from a doubtful prospect: inventory building which, even if it occurred, would be temporary. On average, inventories make about a zero contribution to growth.
Interest rates are behaving normally given the weakness of year-over-year nominal (current dollar) GDP growth which is currently at 3.4 percent, notably only about half the average year-over-year 6.6 percent pace since 1948 (see figure 1). As a rough rule of thumb, 10 year treasuries ought to yield a rate about equal to the pace of nominal GDP growth. In fact, since 1953 the difference (nominal GDP growth minus the 10-year treasury yield) has averaged 40 basis points (bp) (i.e., 0.40), not significantly different from zero, given that the standard deviation of the difference is 290 bp. A standard deviation of 290 bp with a mean of 40 bp translates to the expected difference between nominal GDP growth and 10-year treasuries landing between -250 bp and 330 bp two-thirds of the time. The current gap at 96 bp (3.4 percent – 2.44 percent= 96 bp) is well within the usually employed standard deviation range. In fact, if nominal GDP grows at the current 3.4 percent pace over the coming year, the implied annual pace of growth during Q2 2015 will be just 2.95 percent. That’s just 51 basis points above the current 10-yearyield of 2.44 percent, meaning interest rates are pretty near their long-term trend.
Growth is very weak and interest rates are very low. Nothing new there. Markets – not to mention the Fed – need to wake up and realize that the first step toward solving a problem is to acknowledge it.
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