Manufacturers are expecting increased activity in the coming months, surveys by the regional Federal Reserve banks suggest. But perhaps more important in terms of productivity and global competitiveness, those manufacturers say they plan to increase capital expenditures and spending on technology.
The index indicates an accommodative climate for investment that will help push growth above 4% next year.
Those investments and the strong outlook in the economy will help push growth above 4% next year. But the emergence of the omicron variant of the coronavirus could pose a threat to that outlook.
The strength in manufacturing builds on the continued recovery from the depths of the pandemic, when real capital expenditures declined by roughly 11%. Now, American businesses have a greater appetite for risk, and their willingness to invest in improved productivity underscores our expectations that real nonresidential fixed investment will advance by 5% next year.
This accommodative climate for investment is a byproduct of the evolution of monetary policy over the past half century and is a direct result of confidence in the monetary authorities and their efforts to maintain stability in the financial markets, despite the recent uptick in inflation.
Because of the quick monetary response by central banks after the financial market collapses in 2008 and 2020, the economies of the world did not fall into depression (as was the case in the 1930s).
Instead, commerce was able to resume. And in an environment of low interest rates, the cost of rebuilding has been drastically reduced, while confidence in the monetary authorities’ commitment to stable financial conditions has increased the private sector’s propensity to borrow and lend.
This can be seen in the RSM US Financial Conditions Index, which is a composite measure of the degree of risk (or accommodation) priced into financial assets in the money, bond and equity markets.
In its current reading, the index indicates a level of accommodation that is more than 1.4 standard deviations above normal.
By comparison, the index was 6 standard deviations below normal at the height of the pandemic shutdown—a highly abnormal level of risk priced into financial assets.
Central bankers now accept that monetary policy is transmitted to the economy through financial conditions. For that reason, their missions now include a commitment to maintaining a stable and accommodative investment climate in addition to their traditional roles of price stability and full employment.
In the sections that follow, we’ll look at recent developments in the major asset markets.
Money markets
Money market spreads widened slightly during October and November as investors weighed the perceived threats of runaway inflation and a government default on its debt.
This slight widening comes after the freeze-up of commercial lending at the depths of the pandemic that was followed by an 18-month decline in the spread between interest rates of short-term commercial debt and risk-free government securities.
Is this uptick a sign of impending distress in commercial lending activity? Probably not, but it is nevertheless a symptom of stress in an economy still reeling from the pandemic.
Money market spreads remain below normal levels of risk.
First, money market spreads remain below normal levels of risk, and it is likely that the Federal Reserve would quickly respond to a reckless increase in money market rates just as it did during the initial stages of the pandemic. In addition, the monetary authorities have already anticipated possible distortions that might affect the money markets.
For instance, the circumstances of government income support and the lack of investment alternatives have resulted in an excess of cash sloshing around the financial markets.
Start with the $1.3 trillion of household savings that has been built up, much of it precautionary, and $5.5 trillion of Treasury securities now in the Federal Reserve’s balance sheet. That money needs to be parked somewhere safe.
After the financial crisis, the Federal Reserve presciently created a facility to mop up all that cash each night, using Treasury securities as collateral and now paying an “award fee” of a mere 5 basis points (0.05%) to hold that debt.
By the second half of November, the Fed’s repo and reverse repo operations reached upward of $1.5 trillion, indicating increased demand even at near-zero rates of return.
Another example is the Treasury Department’s stopgap effort to remain under the temporary debt ceiling. With the Treasury on track to default on its obligations in the second half of December if the ceiling is not raised, there has been a limited issuance of short-term T-bills.
All of this has created distortions in the market, as recent pricing shows. The shortened supply of Treasury bills maturing in the second half of December, for example, is commanding higher interest rates than the repo facility, which signals distress in the market. But T-bills maturing in January have lower rates, suggesting that investors expect a resolution.
This abnormal market action points to the potential broader economic damage should Congress not address the nonsensical debate over the debt ceiling. We expect Congress to act responsibly and either eliminate the artifact of the debt ceiling, or more likely increase it to a manageable level.
Still, the money markets remain stable and are unlikely to freeze up without further provocation.
Equity markets
A buy-and-hold strategy on the S&P 500 equity index would have returned 32% for the year ending late November. And with volatility continuing to decline, the stock market has become a virtual gift for investors searching for yield.
And retail investors, lured by commission-free trading, have followed. A recent paper by the economists Zhi Da, Vivian W. Fang and Wenwei Lin found an increase in at-home trading during the pandemic that was abetted by stimulus checks.
And there have been other innovations, beyond the elimination of fees. Fractional trading now allows retail investors to buy a slice of a share with as little as a penny, eliminating barriers to high-priced stocks.
But this all comes at a price. With interest rates at low levels for such a long time, the guaranteed 5% return on fixed-income investments has gone the way of the hula hoop. So investors pour more money into equities and run the risk of being over-exposed when the next crisis arrives.
But until that happens, the increased return and low volatility of the equity markets have helped swell the balance sheets in many households and as a result account for a substantial share of financial accommodation.
Bond markets
Because the threat of runaway inflation had been taken off the table in the developed economies for so long, interest rates became compressed with a notable reduction in volatility during the 2010-19 recovery.
The demand for U.S. securities should continue to dampen the increase in Treasury yields once the Fed begins normalizing rates.
This would argue for the increased attractiveness and safety of investments in Treasury bonds. One theme in the bond market in the year ahead is that central banks’ credibility could become eroded even if top-line inflation falls toward our end-of-year 3% forecast.
While domestic investors might find the equity markets to be more profitable, our trading partners are parking U.S. transactions in Treasurys. Liquidity is guaranteed (assuming Congress doesn’t allow the debt-ceiling crisis to continue), and the economy’s strength should minimize currency risk and add to securities’ total return for foreign investors.
The growth of foreign holdings of Treasury bonds since 2001 serves both as a measure of the globalization of the U.S. supply chain and the attractiveness of holding those bonds.
All in all, the safe-haven demand for U.S. securities should continue to dampen the increase in Treasury yields once the Fed begins normalizing interest rates.
And if the 2010-19 recovery provides the template for this cycle, we can expect the Fed to maintain its balance sheet holdings of securities and then allow for a gradual attrition of those holdings as they reach maturity, with the limited supply of bonds applying downward pressure on yield levels at the margins.
Domestically, spreads in the corporate bond market have continued to fall since the height of the pandemic, signaling reduced perceptions of the risk of corporate default within a strengthening economy.
We would expect Treasury yields to increase all along the curve as the market anticipates the Fed allowing short-term rates to move higher and while sustained economic growth supports higher rates of return on longer-term bonds. In the end, that supports our year-end call for the U.S. 10-year Treasury yield to rise to 2.25%.
