Interest Rates After Inflation May Be a Real Bubble

  • Deutsche Bank says Fed has driven mispricing of real yields
  • Diverence from real GDP seen unsustainable, German bank says

Fed's Neel Kashkari on Interest Rate Dissent, Inflation

U.S. equity and debt markets have ridden a reflationary wave this year, thanks to optimism over the momentum of the U.S. economy.

However, some key gauges for growth sit awkwardly with this narrative. Nominal yields on five-year Treasuries are negative when adjusted for the price outlook. And on Treasury Inflation Protected Securities five years forward, a metric the Federal Reserve uses to gauge long-term inflation expectations, the rate projected for 2022 is falling.

Real rates, which have generally moved in lockstep with real gross domestic product, are some two percentage points below what’s implied by the momentum of the U.S. economy, an unsustainable divergence, according to Deutsche Bank AG.

"We see real rates as extremely misvalued if not in a bubble," Deutsche Bank analysts, led by Chief Global Strategist Binky Chadha, wrote in a note on Friday.

Inflation-adjusted yields can’t defy economic gravity for much longer, they argue, setting the stage for a correction that may imperil risk appetite in bond markets over the summer.

Low real yields are in stark contrast to post-election expectations when analysts projected a higher public deficit and uptick in corporate spending for this year -- an environment typically associated with a rising real cost of capital.

Pessimism over President Donald Trump’s agenda -- legislative hurdles for pro-growth policies, and fears that a protectionist lurch that may raise prices -- suggest investors are ensnared by "stagflation concerns," Bank of America Corp. noted last month, citing the disconnect between rising break-evens and falling real yields.

Chadha and team, by contrast, pin the blame squarely on the Fed.

Bond markets have priced in an overly dovish monetary stance, they say, consistent with the view the U.S. economy is ensnared in secular stagnation -- the proposition that economic growth and the natural rate of interest are structurally low relative to the pre-crisis era.

Fed Chair Janet Yellen restated the case for policy rates staying anchored by historical standards, at a press conference that accompanied last week’s rate increase. She added the neutral rate -- the inflation-adjusted level that’s consistent with the U.S. economy expanding at its full potential without overheating -- is expected to “rise somewhat over time” as some of the effects of the crisis wear off.

Strategists at the German bank reckon real rates will snap higher sooner than the Fed likely anticipates -- amid an upturn in core price pressures.
At the heart of their argument: a tightening labor market is likely to fuel inflation in the coming months -- preserving the health of a monetary relationship known as the Phillips Curve -- when adjusting for the impact of the dollar. What’s more, diminished slack in the jobs market will boost the efficiency of U.S. economic output, they conclude.

Judging by benign market pricing, that view remains an outlier.

Real rates "are far from a bubble" or overly distorted through monetary policy, said Steve Feiss, an interest-rate strategist at broker-dealer Government Perspectives LLC in Marlboro, New Jersey, citing high demand for liquid and safe assets and a weak outlook for growth.

"The Fed wants to nudge real rates higher, and as commodity base effects dissipate, we could see that," said Naufal Sanaullah, a trader and founder of the website MacroBeat. "But I think Trump will want to utilize low real yields as a way to stem dollar-appreciation pressure."

For now, a slew of banks, including Goldman Sachs Group Inc. and Bank of America, are advising clients to shun longer-dated obligations, citing the risk of an uptick in real rates. Long-maturity debt is more vulnerable to swings in rates, as witnessed in the bond-market routs in 2013 and 2015.

Chadha sees markets pricing in higher real rates in June, guided by hawkish guidance from the Fed. "We expect a clear upward trajectory in core inflation to become apparent later this year as the dollar shock begins to fade, which we expect will make the Fed anxious and reiterate or up its guidance."

It could be an eventful summer.

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