Two quarters of strong productivity numbers are hardly enough to support a decades-long reversal, but if they continue, the recovery might last longer than most economists expect. With the number of millennials entering the workforce now moderating at the same time as more baby boomers are retiring, America is going to run low on workers at the turn of the decade. Washington, meanwhile, is in no mood to expand immigration, which is the only way to increase population in the short term.
Demographics and productivity may be the long-term problems, but managing interest rates late in the cycle will capture most investors’ attention in 2018. Lofty profit expectations continue to lift the stock market, but yields on 10-year Treasurys were lower at the start of 2017, indicating the bond market isn’t as impressed with the economy as equity investors.
As of November, the Fed was telling investors it would raise rates three times in 2018, yet Gundlach noted that the bond market is pricing in only one hike. Who is right? The Fed was right in 2017 saying it would raise rates three times and following through while the bond market had baked in only one hike.
Jerome Powell, the newly appointed president of the Fed, controls the direction of quantitative tightening over the next years. In all likelihood, Powell doesn’t want his legacy to be that of the guy who inverted the yield curve (pushing short-term interest rates to higher levels than intermediate- or long-term interest so that the curve no longer has an upward slope) and set the nation on the road to recession, notes Jim McDonald, chief investment strategist at Northern Trust.
Powell’s predecessor, Janet Yellen, managed to bring about an end to zero interest rate policy (ZIRP) without causing a recession. She also left Powell with some limited ammunition to lower interest rates in the event of another economic downturn, a luxury that central bankers at the ECB don’t have.
Nonetheless, the yield curve isn’t very far from inverting. “We think this will constrain the Fed from raising rates too fast,” McDonald says.
Yield curve inversions often signal recessions and occasionally equity market retreats, but those two events can take years to occur after the curve inverts. In the last 40 years, McDonald notes the curve inverted four times, but only once was it followed by a “sustained stock market decline” and that was after the dot.com bubble burst.
Frequently, there is a substantial lag between inversions and recession, McDonald recently told clients. After the yield curve inverted in late 2005, it took “two full years” before a recession arrived.
“An inverted yield curve led the early 1980s recession by 17 months, the late 1980s/early 1990s recession by 18 months and the early 2000s recession by 13 months,” McDonald wrote. That’s why he thinks the Fed will be careful not to “flatten the yield unnecessarily.”
When most strategists are asked to list their biggest fears, a policy mistake by the Fed and other central banks during a tightening cycle often tops the list. Rosenberg and others expect the Fed to ultimately make a mistake this time around as well.