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Real US interest rates are sanguine about the budget and pessimistic about growth

Global Economy

Real US interest rates are sanguine about the budget and pessimistic about growth

America’s fiscal stance has loosened a bit in the past few months. Tax changes passed at the end of last year plus a recent budget deal to remove earlier caps on spending will combine to increase the federal deficit by about 1.6 percentage points of gross domestic product in the next few years. By 2027, the federal government’s net borrowing could amount to as much as 7.3 per cent of GDP.

Some people think this is a problem. Traders, however, do not.

The government’s real long-term borrowing costs are lower now than they were at the beginning of 2016. “Bond vigilantes” are clearly unconcerned about the government’s ability to fund its debt issuance. But this is not good news for the politicians — real yields also imply economic stagnation over the next few decades and significant risk of a downturn in the next few years.

About a tenth of the debt sold by the US Treasury to investors is indexed to inflation. The principal and interest coupons of these bonds grow over time with the consumer price index. Investors are protected from inflation, which means the yield on these bonds represents the real value of money. There is no embedded expectation of inflation nor any inflation risk premium to compensate investors for uncertainty around their inflation forecast. There is only the real interest rate.

The Federal Reserve Board publishes daily data on these real interest rates at 5-year, 7-year, 10-year, 20-year, and 30-year horizons.

Since the trough on the eve of the “taper tantrum” in April 2013, real 5-year interest rates have increased about 2.1 percentage points. But most of that increase occurred in the middle of 2013. Shorter-term real rates are barely higher than they were at the end of 2015, although they have steadily increased since last summer. Whatever drives real interest rates — the budget outlook, the growth outlook, monetary policy, other random variables — simply hasn’t changed much between now and then:

Longer-term interest rates tell a different story. The 20-year real yield is substantially lower now than in the heady days at the end of 2013, even if it has risen slightly in the past few weeks:

The history of the 30-year inflation-indexed bond is shorter than for the other tenors, but it still contains useful information. The 30-year yield is the same as the geometric average of the 20-year yield plus the 10-year yield starting 20 years from now. This far-forward rate is about as low as it’s ever been in the past eight years, even with its small recent rise:

That is not what you would expect if traders were exercised by the prospect of large future budget deficits, nor is it what you would expect if traders were optimistic about the growth outlook.

There is also useful information in the absolute difference between shorter and longer-term real yields. If 10-year yields are higher than 5-year yields, for example, then that probably means traders expect some combination of faster growth and tighter monetary policy in the future relative to today.

During the worst of the crisis, the real yield curve was deeply inverted — real 10-year rates were about 1.5 percentage points lower than real 5-year rates. By early 2010, the prospect of monetary and fiscal stimulus had pushed 10-year real rates about about 1 percentage point above 5-year real rates. This 5s10s spread stayed around that level until the end of 2013. In the past year it has collapsed to zero:

This curve flattening does not necessarily mean recession is imminent, but it also suggests the future will not be much different from the way things are right now. Market pricing implies those hoping for a great acceleration will be disappointed. The better future promised in the past has already arrived:

There is little reason to fear the consequences of looser fiscal policy. If bond traders are sanguine, you should be too. But their calm comes at the cost of a gloomy prognosis for longer-term growth.

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