Good news is bad news in the US economy
‘It’s a remarkably positive set of economic circumstances,” said Federal Reserve chairman Jerome Powell last week. “And there’s no reason to think it can’t continue for quite some time”. The US economy grew at a buoyant annualised rate of 4.2pc between April and June. New survey data suggest that, in the wake of Donald Trump’s corporation tax cuts, there’s more to come.
As companies boosted hiring in September, activity across the services sector – accounting for more than two thirds of the world’s largest economy – raced to a 21-year high. “The US economy is doing extremely well,” said Chicago Fed president Charles Evans last week. “The fundamentals are strong”.
If that’s so, why are there widespread concerns America’s financial markets could soon collapse? And why did such fears just intensify after the release of economic news that the Federal Reserve boss himself described as “remarkably positive”?
The reason, of course, is we’re still in the post-crash Alice-in-wonderland world where “good news is bad news”. Signs of economic strength mean central banks could curtail, sooner rather than later, the ultra-loose monetary policy that’s prevailed since the 2008 crisis.
That, in turn, spooks financial markets – bloated after years of interest rates nailed to the floor and having gorged on the drip-feed stimulant that is quantitative easing. Investors have borrowed heavily over the last decade, so financial markets are highly “leveraged”. That makes them prone to sharp downward lurches as share-price falls mean loans are called in, with indebted investors then forced to dump stocks at any price. The US stock market registered double-digit gains in five of the past 10 years, soaring by 25pc in 2017. Valuations are flashing red. The S&P’S 500, the bellwether index of leading shares, is now priced higher, as a multiple of annual earnings, than just before the 2008 collapse.
The Fed has already curtailed QE, of course – bringing America’s virtual money-printing programme to an end back in late 2015. Since then, though, the European Central Bank and the Bank of Japan have carried the QE baton, channelling the equivalent of tens of billions of dollars into global markets each month, keeping stocks everywhere pumped up.
The Fed has also led the charge on interest rates, imposing eight successive rises, in quarter percentage point increments, since US QE ended. The pace has lately quickened, with the last three Fed increases coming this year, including last month – the latest 0.25pc move taking the benchmark to 2pc-2.25pc.
So far, with central bankers in Frankfurt and Tokyo keeping the QE sluice gates open, US financial markets have absorbed this gradual tightening of interest rates. What’s now changed, though, is the tone of Powell’s rhetoric.
As recently as late August, at the Wyoming Jackson Hole summit, the Fed supremo talked of moving “conservatively”, noting that “when unsure of the potency of a medicine, start with a somewhat smaller dose”. Such dovish words reassured investors rates wouldn’t rise too far too fast.
But over the past month, as the US economy has strengthened, Powell has changed his tune. “Interest rates are still accommodative,” he said last Wednesday, “but we’re gradually moving to a place where they’ll be neutral” – that is, neither restraining nor boosting the economy. “We may go past neutral,” Powell continued, “but we’re a long way from neutral at this point, probably”.
Don’t fret if that sounds like gobbledygook. Talking in elliptical riddles is what central bankers do. If you’re not confused, you don’t really understand what’s going on. The thrust of what Powell is saying, though, is that rates will not only keep
rising, but may go up faster than previously assumed. And that’s why global financial markets, which have long been precarious, are this weekend doused in doubt.
Financial analysts tend to focus on the vagaries of the stock market, because that’s where the bulk of most peoples’ investments are. But bond markets are also massively important – seeing as they generate the interest rates that determine the actual cost to consumers, firms and countries of both fresh borrowing and servicing existing debt.
Last week, as speculation mounted that the Fed might up the pace at which benchmark rates are increased, the US 10-year Treasury yield hit a seven-year high – going above 3.22pc for the first time since 2011. And as the Fed keeps raising the benchmark, such market interest rates could spiral upward much more – seriously destabilising global commerce, as both stocks and bonds become less attractive.
Stronger US growth means investors demand higher yields to lend money to firms and the government, pushing bond prices down. That’s partly because other opportunities look more attractive as the economy expands. But the main reason is that growth tends to push up inflation – which means the fixed “coupon” that most bonds regularly pay becomes less valuable in real terms.
Powell says “an inflation surprise to the upside … isn’t in our forecasts”. Such circular logic from the Fed doesn’t convince. With unemployment down at just 3.9pc, and the employment-intensive service sector booming, US wage pressures are rising. Amazon’s decision last week to increase its lowest wage to $15 (£11.47) an hour, well above the $7.25 federal minimum, was partially driven by criticism specific to the tech giants. But it points to a broader trend of firms struggling to recruit from a tightening labour market.
US inflation has averaged 2.7pc over the last six months. Rising wages and dearer oil – Brent crude is now above $80 a barrel – could see it go much higher. With the ECB set to wind down QE later this winter, another large central bank will withdraw from the emergency measure of buying government bonds, pushing up yields further.
The big picture is that global bond yields are set to rise, driven by a booming US economy. That will lead to higher borrowing costs everywhere. Consider, also, that combined public and private debt across the world now stands at $182 trillion according to the International Monetary Fund – some 60pc higher than in 2008.
“I don’t think there is an alarm going off,” said Boston Fed president Eric Rosengren last week. “But I do think there are a lot of yellow lights”. The era of “easy money” is ending – and the upshot won’t be pretty.
‘Global bond yields are set to rise, driven by a booming US economy. That will lead to higher borrowing costs everywhere’