Secular Stagnation Is A Policy Choice

In my most recent posts, I have been saying that bond markets are pricing in secular stagnation scenarios based on how shallow the yield curve is. And that will force the Fed to pause its policy normalization path.

But secular stagnation is a policy choice. And that is something I thought I should highlight in view of UK Prime Minister Theresa May’s change of heart in pursuing austerity. 

Now, if you look at the US government bond yield curve, the short end of the curve is selling off, with the 2-year Treasury ending last week near a March 2017 peak of 1.40%, which was the highest since November 2008 at the depths of the last recession and financial crisis. And that makes sense because interest rate futures are pricing in a virtual 100% probability that the Federal Reserve will raise the federal funds rate 25 bps to the 1.00%-1.25% range at the Federal Open Market Committee meeting that ends on Wednesday. The futures market is also expecting at least one more interest rate hike in 2017, with the market-implied probability of another hike by year-end at 55%.

At the same time as the bond market is sending this signal, the curve is flattening. We go from 1.33% on two-year bonds to 2.20% for 10-year and 2.86% for 30-year paper based on figures at the end of last week. That’s less than 100 basis points for the 2-10 spread, a marker for weak expected nominal growth.

And so, as I put it last week, “[a]t some point, either the yield curve flattening will stop or the Fed will stop. During the energy CapEx bust, the Fed already showed us it is responsive to data. And so to the degree the yield curve continued to flatten, I believe it would show up as poor economic data and the Fed would be forced to yield. Alternatively, the flattening could end due to a re-acceleration of growth, ending the whole speculation about secular stagnation, at least temporarily.”

My bet is on the Fed’s pausing. Why? Policy choices.