When we talk about consensus forecasts for the economy and interest rates, we tend to think of the forecast consensus of Wall Street’s top economists. But what matters most to market interest rates is the consensus forecast of bond traders, especially the forecasts of the big, global bond trading entities. For at least the fifth year in a row, those two consensus groups are divided.
For the past five years, including the 2018 forecasts, economists have been projecting a stronger economy. They’ve also drawn the logical conclusion that rates would rise because of this. Economists have been absolutely right on the economy and absolutely wrong on interest rates. They did score a victory in 2017 on the rise in the funds rate, but longer-term rates undershot projections.
Now, economists are predicting an improved economy boosted by the tax reform bill and are looking for a funds rate of 1.75% to 2.00% and a 3.00% 10-year note rate by the end of 2018.
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The bond trading crowd has been forecasting economic gloom for the past five years to justify why rates would stay low or go lower. They have been dead wrong on the economy but right on rates.
Bond bulls don’t like to admit it, they prefer the fundamental argument of economic gloom and doom, but the real reason they have been right on rates is because of central bank actions: ultra-low rates — extending far beyond the need — combined with massive securities purchases.
The result? Central banks have destroyed any credibility of the yield curve.
The yield curve has been on a flattening trend for some time. Bond traders are predicting the yield curve will flatten further in 2018 as the Fed raises the funds rate but longer-term rates stay low. How about a year-end funds rate of 2.00% and a matching 10-year note yield rate?
Central banks have destroyed any credibility of the yield curve.
Or, there is another non-consensus scenario I am beginning to lean toward. How about a year-end funds rate of 1.50% and a 10-year note rate of 3.50%?
This forecast starts with the Federal Reserve board. Incoming chair Jerome Powell was appointed to the board by President Barrack Obama but was nominated to serve as chair by President Donald Trump. Powell is considered a Yellen clone, but we don’t know how he will act when he assumes his new role. Until now, he has been in a subordinate role. He is a Republican and has no economic or market background. There is nothing Yellen-like about that.
Trump has already filled two vacancies on the seven-person board and has two more slots to fill. That means Trump will have the board chair and four of the six remaining seats. Although the Federal Reserve board is designed to be non-political, let’s get real. Will this board really take actions next year that could run counter if not negate the impact of Trump’s tax bill?
With the Fed’s increase in the funds rate in December, the Fed has, for the first time in nine years, A change in the funds rate and 10-year note would bring the yield curve back into the realm of normal after years of being out of bounds. achieved a neutral policy. The funds rate now matches the Fed’s preferred rate of inflation, the core personal consumption expenditures (PCE) index. If inflation doesn’t rise early next year or rises only modestly, the Fed could refrain from tightening regardless of the economy.
This would undermine the bond bulls’ case that the Fed would go too far in tightening. But the bond bull case will take another hit next year. Unless something dramatic happens, the Fed will be out of the securities buying game completely by the fourth quarter, and the European Central Bank’s purchase program will be winding down.
The two biggest buyers of bonds will be all but gone. In the meantime, the U.S. deficit will require significant new funding.
A too-loose Fed combined with a shrinking buyer pool should equal a bond bull revolt. A 1.50%-1.75% funds rate and a 3.50% 10-year note rate would bring the yield curve back in the realm of normal after years of being out of bounds.
This “normal” forecast is certainly an outlier, but isn’t it time for something different and something normal?
Dwight Johnston is the chief economist of the California and Nevada Credit Union Leagues and president of Dwight Johnston Economics. He is the author of a popular commentary site and is a frequent speaker at credit union board planning sessions and industry conferences.
Credit unions have made significant gains since the Great Recession started 10 years ago. Third quarter credit union growth trends surged past that of community banks and the overall banking industry. Measures such as loans, shares, capital, and membership have all reached new levels. These gains are all notable and meaningful; however, they are backward-looking. The important question to ask is: Where will credit unions be in the next 10 years? In this issue of Strategy & Performance, learn why now is the time for credit unions to challenge themselves.