Traders on the floor of the New York Stock Exchange react as Federal Reserve Chair Jerome Powell speaks on a TV, in New York on Nov. 2, 2022.Brendan McDermid/Reuters
John Rapley is an author and academic who divides his time among London, Johannesburg and Ottawa. His books include Why Empires Fall (Yale University Press, 2023) and Twilight of the Money Gods (Simon and Schuster, 2017).
Although Kamala Harris has struggled to convince many Americans of it, the evidence is clear: America has never been richer. Most of us thus regard Trump voters who buy his shtick that Joe Biden wrecked the economy with bemusement. But if bond markets are telling us something, it could just be they see something the rest of us don’t.
On the face of it, the economy enters the November election in what is possibly its best-ever shape – output rising, inflation falling, real wages up and jobs aplenty. This happy mix means the Federal Reserve has been able to start cutting interest rates, which will further encourage businesses and households to spend, adding fuel to the economy.
Amid such optimism, the stock market keeps setting new records, with most market indices at their all-time highs. House prices, too, after falling slightly amid the Fed’s rate rises in 2022, are now back on a tear. Taken together, net household wealth, which suffered a brief setback during the pandemic, is now almost fully back to its peak. Once they tot up their assets and subtract their debt, the average American household now is some $160,000 in the black. Richer than ever, with decent jobs and rising incomes, Americans have every reason to believe the good times will keep rolling, a stark contrast to the gloom pervading many of their G7 partners.
So why does anyone doubt it? One problem with aggregate data is that while they offer a good snapshot picture of the overall economy, they hide a lot of variation. That record wealth, for instance, is unequally spread, with some people soaring but many others struggling under mountains of debt.
The same can be said of inflation. Take housing. It is one of the many variables central banks put into the mix when they work out the inflation rate, and typically it makes up about a third of the Consumer Price Index. But here’s the thing: If you own your house and are mortgage-free, you don’t bear much expense, so your own inflation rate will be lower than the headline figure.
In contrast, if you rent or are on the market for a first home, your effective inflation rate will be higher. Quite a lot higher, in fact, because at the moment shelter inflation is running more than double the overall rate – in Canada, it’s even worse, and is approaching triple (which no doubt helps explain why young people have soured so much on the governing Liberals).
That divergent inflation may be causing not just a cognitive dissonance among voters, with some feeling more positive than others, it may point to a problem deep in the economy. Some signals emanating in a couple of corners of the market suggest that even among the richest and savviest, anxiety about inflation lingers.
Despite the insistence of central bankers that they have vanquished it, there may be good reason to doubt they have. Gold prices keep setting new record highs, which may be a sign that trouble lies ahead. More recently, bond markets also have begun flashing a warning sign.
Since the Federal Reserve began its rate-cutting cycle last month, 10-year bond yields have risen half a percentage point. Despite easing economic conditions, investors are growing cold on lending money to the government. That could indicate investors are judging the Fed cut rates too early, and that inflation will return. Close analysis of long-term trends in the inflation data suggest they may be onto something.
It bears noting that in contrast to its usual practice, whereby the Fed cuts interest rates when the economy starts slowing sharply, this time it’s easing at a time when the economy remains strong. Some economists are thus on the lookout for the inflation rate to turn back upward, possibly sometime next year. Add to that concerns the national debt is becoming unsustainable, and investors need higher yields for lending money to the government.
Higher bond yields will eventually filter through to other interest rates, complicating the Fed’s plans to engineer a soft landing. They’re already dragging bond rates higher overseas, as foreign investors sell local bonds to buy higher-yielding American ones. For instance, despite the Bank of Canada cutting rates by three-quarters of a percentage point, the yield on a 10-year Canadian government bond is now higher than it was at the start of the year.
Markets and the Fed can’t both be right. If inflation reports continue to deliver good news, bond yields will eventually reverse course and follow Fed rates down. But if bond markets are vindicated and the Fed is shown to be wrong, it will have to overcorrect, which could get ugly for asset markets.
That won’t happen for a while, though, so stock markets will probably keep rallying for now. But if that small dark cloud on the distant horizon keeps getting bigger, prepare for the deluge.