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Yields Below Growth Rates Signal Trouble Ahead: Cutting Research

Photographer: Simon Dawson/Bloomberg

An estate agent arranges a photographic display of a residential property up for sale in London. The U.S and U.K are in the early stages of a typical post-real-estate-crash resurgence, Goldman Sachs Group Inc. analysts Julian Richers and Noah Weisberger wrote in a Jan. 22 research note. Close

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Photographer: Simon Dawson/Bloomberg

An estate agent arranges a photographic display of a residential property up for sale in London. The U.S and U.K are in the early stages of a typical post-real-estate-crash resurgence, Goldman Sachs Group Inc. analysts Julian Richers and Noah Weisberger wrote in a Jan. 22 research note.

When yields on long-term government securities are below nominal growth rates for a prolonged period, trouble may be brewing.

Overheating in financial markets has often arisen when interest rates linger below an economy’s sustainable expansion level, Citigroup Inc. analysts led by Nathan Sheets wrote in a Jan. 20 report.

“There have been episodes in recent decades -- such as the years before the financial crisis, as well as the Japanese asset bubble, the U.K. housing bubble of the late 1980s, and the U.S. dot.com bubble -- when long-term interest rates have been allowed to slip below nominal growth rates, with the results bringing great sorrow,” they said.

In the cases of Japan and the U.S., policy makers at that time weren’t trying to provide stimulus when long-term yields were lower than growth rates, the economists said. Former Federal Reserve Chairman Alan Greenspan in 2005 called the anomaly of low long-term debt yields during a period of rising Fed rates a “conundrum.”

The rule that yields should be higher than growth rates could be a way for central banks to crosscheck the appropriateness of their policies, the analysts said.

For example, should central bankers see long-term yields slip below growth rates “when they are not gearing policy to be exceptionally stimulative, monetary policy and macro-prudential policies should probably be tighter than would otherwise be the case,” they said.

While there are times when officials have legitimate reasons to drive borrowing costs down and spur economic expansion, they should be wary of the implications.

“Our reading of the experience of the past few decades is that such policies should be pursued cautiously,” the economists said.

* * *

Doomsayers take note: the U.S. and U.K. economic recoveries have room to accelerate after their housing busts.

Both countries are in the early stages of a typical post-real-estate-crash resurgence, Goldman Sachs Group Inc. analysts Julian Richers and Noah Weisberger wrote in a Jan. 22 research note. The recoveries can be compared with past episodes of housing-market crashes around the world.

Richers and Weisberger analyzed data from before and after 24 house-price busts since 1970 across 15 nations from the Organization for Economic Cooperation and Development, to test the strength and durability of the U.S. and the U.K.’s current performance. Each crash was defined as a period when home prices fell by more than 15 percent, they said.

Economic contractions that were driven by housing busts tended to be deep and with wide-ranging damage, while their recoveries were slow, protracted and long-lived, the analysts said.

In both countries, “house prices have started to recover, but are likely to continue to appreciate for several more years,” they wrote. “Economic growth has returned to trend, although output gaps remain wide open, unemployment rates are not a constraint and inflation is still subdued. Putting all that together, and using historical housing busts as a measuring stick, suggests that economic growth in the U.S. and the U.K. has room to accelerate, and can continue to do so for some time.”

* * *

Who’s afraid of a little more inflation?

Central bankers should move away from considering zero to be the best inflation rate. That view has effectively created a 2 percent target for price stability after taking into account outcomes such as productivity gaps, says Natixis Securities chief economist Patrick Artus.

It would be “optimal” to have a higher price target as it would give central banks more room to act during economic slowdowns, or to push down real wages, the Paris-based analyst wrote in a Jan. 21 note.

“If inflation was higher during growth periods, central banks’ key intervention rates would, at equilibrium, also be higher,” Artus said. “This would enable central banks to lower their interest rates more during recessions before hitting the non-negativity constraint of nominal interest rates, and it would therefore enable monetary policy to be more counter-cyclical.”

Policy makers in the U.S., the U.K., the euro region, and recently Japan, have an inflation target of about 2 percent.

“We understand well that increasing central banks’ inflation target is dangerous, especially because inflation expectations are anchored at the level of the target inflation rate,” Artus said. Even so, higher inflation would also make it possible to reduce public debt ratios, he said.

* * *

Aging Americans may be obscuring the outlook for the U.S. labor market because their retirements hide the true cause of the decline in the unemployment rate.

Even as the economy recovers and companies increase payrolls, labor participation rates probably won’t improve by much, Drew Matus, deputy U.S. chief economist at UBS Securities LLC in Stamford, Connecticut, wrote in a Jan. 17 note. The reason is structural, he said.

“The primary cause for the decline in participation is demographics rather than changing behavior patterns,” he said.

The U.S. has an aging population, and the labor participation rate of those who are 55 and above is half that of so-called prime age workers between the ages of 25 and 54, the report showed.

Workforce flows data showing an increase in the number of workers moving from “employed” to “not in the labor force” supports the view that the drop in participation rates may persist. Payroll growth averaging 200,000 a month should continue to bring down the jobless rate under all except the most aggressive labor force expansion estimates, Matus said.

* * *

While monetary policy theoretically shouldn’t affect the exchange rate of a currency and its long-term trend, this cycle may be different, according to Bank of America Corp strategists.

As central banks in major advanced economies start to unwind the unprecedented expansion of their balance sheets, their exchange rates may be affected, London-based currency strategists Athanasios Vamvakidis and Myria Kyriacou wrote in a Jan. 22 report.

The combined balance sheets of the Fed, the European Central Bank, the Bank of England, the Bank of Japan and the People’s Bank of China have more than doubled to 33 percent of gross domestic product of their total economies from 14 percent since early 2007, they said.

“Unwinding this balance sheet expansion could take years, and is likely to affect both the actual and the equilibrium levels of exchange rates,” the strategists said.

Bank of America’s models suggest the Australian dollar is overvalued, while balance sheet changes will weaken the euro against the dollar for “years to come,” Vamvakidis and Kyriacou said. Models show the yen is currently undervalued, and could depreciate further as the Fed reduces its assets and liabilities and the Bank of Japan does the opposite, they predict.

To contact the reporter on this story: Shamim Adam in Singapore at sadam2@bloomberg.net

To contact the editor responsible for this story: Stephanie Phang at sphang@bloomberg.net

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