At this point in the tightening cycle, the focus should be on whether the desired conditions have been met, and so far, they haven’t. The re-pricing of higher-for-longer rates is justified due to several factors. Inflation remains moderately high, wage growth is too strong to allow inflation to settle within the desired target range, labor market conditions are robust, and real growth is not weak enough to warrant an easing.
A notable 5.4% estimate of growth for the third quarter has been reported by the Atlanta Fed’s GDPNow following an unexpectedly strong retail sales report. Additionally, consumer prices saw a 3.7% year-over-year increase in September, with an unemployment rate of 3.8% and a 4.5% year-on-year growth in the employment cost index for the second quarter.
Looking ahead, the Bridgewater team predicts that to achieve a risk premium in bonds, a bond yield of 5.5% or higher will be necessary if the T-bill rate remains at 5% or higher. With central banks withdrawing from bond buying and an influx of supply, demand will need to come from private sector investors who will require a risk premium in comparison to cash.
As of now, the 3-month Treasury bill BX:TMUBMUSD03M has a yield of 5.5%, while the 10-year Treasury BX:TMUBMUSD10Y has a yield of 4.85%.
The adjustment in bond yields is a well-justified response to prevailing economic conditions. However, it is clear that this adjustment is far from complete, and the market will continue to closely monitor the fulfillment of desired conditions in the coming months.
Rising U.S. Government Borrowing Rates and Its Implications for the Economy
The U.S. government is expected to experience a surge in borrowing on the long end of the yield curve, surpassing the current demand for bonds. This situation could have significant consequences for the economy and financial markets.
Impact on Growth and Equity Market
According to experts, this new stage of the tightening cycle is likely to exert “grinding pressure on growth.” Additionally, they anticipate that the equity market will become less competitive compared to bonds.
Despite the S&P 500’s 14% gain this year, it has recently experienced a 5% decline from its peak in late July.
Challenging Outlook for Equities
Given the persistent growth constraints and restrictive policies discouraging credit acceleration, it is unlikely that an increase in earnings will restore equities’ competitiveness against bonds. In fact, experts believe that earnings could further impede equity performance. Therefore, revitalizing risk premiums in both equities and bonds may necessitate higher yields and lower prices, according to their analysis.
Exception: AI Breakthroughs and Productivity Boost
However, there is one potential exception to this outlook. If there is a breakthrough in artificial intelligence (AI) and large language models that significantly enhances productivity, then the current pricing dynamics could be justified. A rise in productivity would imply lower inflation rates, which in turn would make discounted growth in earnings more reasonable. Furthermore, higher real interest rates could be sustained with lesser adverse effects on the economy. Although bond yields would still need to rise to offer a risk premium in line with the new equilibrium level of real short-term interest rates, both the economy and equities would likely be more resilient to these interest rate effects.
In conclusion, market experts foresee a substantial increase in U.S. government borrowing rates on the long end of the yield curve. This development is expected to exert pressure on growth and make equities less competitive relative to bonds. Nonetheless, the potential for AI breakthroughs and enhanced productivity could alter this outlook, thereby enabling a more favorable pricing environment and easing the impact of rising interest rates on the economy and equities.