A change in the trajectory of interest rates is more likely to come from a change in the political environment than a change in the economic environment.
Last month’s drop in long-term Treasury yields spooked many market watchers who fear recession and another prolonged period of sluggish economic growth. But they’re watching the wrong threat. While low interest rates in the early part of this decade were caused by economic pessimism—high unemployment and excess debt in the wake of the great recession—low interest rates today are more reflective of political uncertainty and pessimism. A change in the trajectory of interest rates is more likely to come from a change in the political environment than a change in the economic environment.
The best way to show that this is the case is to observe what events have caused markets to move unexpectedly over the past few months. Without fail, a flare-up in the trading relationship between the US and China has rocked markets and sent interest rates lower. Signs of a detente or the prospect of talks—like we got last Wednesday—have led to stock market rallies and a rebound in interest rates. Negative headlines related to Brexit have unsettled markets, with the British pound falling and the dollar rallying. Dollar rallies put stress on global markets and led to interest rate declines.
On the flip side, whenever we see signs that a “hard Brexit” is less likely, the British pound rallies. The news isn’t all bad, but it is so uncertain that markets are wavering day by day.
The negative trends in global manufacturing and investment are in large part downstream effects of politics rather than a traditional downturn driven by excess investment and debt. The trade war between the US and China has led to a decline in global trade and business confidence, the impact of which has fallen particularly hard on manufacturing and export-sensitive Germany.
Sluggish economic growth in Germany has led to German yields going increasingly negative. Increasingly negative yields in Germany have led to yields in other countries falling to match the move in German rates, with the correlation between German yields and US Treasury yields in recent months being close to one. But again, the markets are uncertain, not panicked: Many investors continue to hope that Germany will consider fiscal stimulus to avert or escape recession. It is pessimism about politics that is baked into interest rates in the developed world. The thinking goes something like this: The trade war between the US and China will never get better, and may in fact get worse. A disruptive hard Brexit could happen in the near future. Economic confidence will continue to suffer, with global trading volumes falling and businesses unwilling to invest until the geopolitical environment is more stable. Germany falls into recession, but refuses to do enough fiscal stimulus to match its economic headwinds. And political dysfunction in England and the US prevents a large-scale fiscal stimulus response to offset the negative impacts of Brexit and the US-China trade war. That pessimistic thinking is all sadly plausible.
With politics as the reason for the economic malaise, could politics pull us out of this as well?
Perhaps in 14 months President Donald Trump will lose the election to a free-spending Democratic candidate like Bernie Sanders or Elizabeth Warren who pledges to end the trade war with China. The tariff burden on households would lift, business investment would recover, and government spending could surge. And imagine a political turnaround in Britain, like the unlikely scenario of Labour’s Jeremy Corbyn becoming prime minster. The wealthy might loathe it, but such a shift would represent a dramatic reordering of the political landscape and could provide the upward shock to inflation and interest rates that markets are not prepared for.
Other sorts of political catalysts are possible as well. Maybe a political shift in Germany will lead to more of a willingness to use fiscal stimulus to support German and global economic growth. Maybe the Federal Reserve, either on its own or forced by the White House, will shift its focus even more to supporting economic growth and the labour market rather than worrying about inflation. If markets are going to be caught off guard—by good news or bad—the shock is more likely to be political than economic.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.