When long-term interest rates were surging earlier this year, Federal Reserve officials cheerfully interpreted the move as a vote of confidence in the U.S. economic outlook.
By the same logic, this month’s plunge in bond yields—taking the rate on the 10-year Treasury note to as low as 1.25%, the lowest since February—suggests investors may be having some second thoughts on the topic.
That doesn’t mean they’re expecting a bust: the economy is growing fast and forecasters are still relatively upbeat about growth in the second half of this year and into 2022. What appears to be happening instead is that bond investors are abandoning thoughts of a post-pandemic paradigm shift toward faster growth, and downplaying fears of runaway inflation—at least for now.
No longer do they see continuous dollops of government money lifting longer-term growth to something closer to 3% than 2%. Nor do they see a rejiggered Federal Reserve monetary strategy succeeding in boosting inflation to its average 2% goal.
With expectations of further budget-busting fiscal packages fading and more hawkish rhetoric from the Fed, the bond market’s focus has shifted toward a slowdown in growth next year and beyond, as massive budgetary and monetary stimulus gets scaled back.
“It’s a back to the future, a snap-back to 2019,” when structural forces such as an aging workforce and a shortage of global demand constrained growth and inflation, said Nathan Sheets, a former Fed and Treasury Department official who is now PGIM Fixed Income chief economist.
Other factors are at play in the bond-market rally. Even with their recent steep decline, yields on U.S. Treasuries are well above those available on government debt in Europe and Japan, and thus remain attractive to foreign buyers.
Many market players also appear to have been caught off guard by the sudden shift in sentiment, forcing them to cut their losses and close their short positions, fueling the rise in prices.
And lurking in the background is the persistence of the pandemic and the risk that new, more dangerous strains of Covid-19 could set back the nascent global economic recovery.
Forecasting a U.S. slowdown next year is something of a no-brainer. Thanks to the unprecedented fiscal largesse and a full-scale reopening of the economy, growth this year is forecast to clock in at 6.6%, the second-best year since 1966, according to economists polled by Bloomberg. So some downshifting is to be expected, to a still healthy 4.1% in the Bloomberg survey.
But that doesn’t mean it won’t be noticeable.
“It’s like you’re in a car and fiscal and monetary policy are flat on the accelerator,” said Mark Zandi, chief economist at Moody’s Analytics. “If you take your foot off the accelerator—even if you don’t put it on the brake—it feels different. All of sudden you start to slow quite significantly.”