Monetary policy has reached a pivot point, bringing an increased probability for sustained growth and easing fears of a premature end to the business cycle.
The RSM US Financial Conditions Index turned positive in January and has continued to indicate normal levels of risk in financial securities.
This improvement should underscore the positive outlook that will be featured in the Federal Open Market Committee’s Summary of Economic Projections for June that will be published at the end of its two-day meeting on Wednesday.
All signs point to a global shift toward lower interest rates. After more than two years of rate hikes, extremely tight monetary policy, and now slowing growth, the Bank of Canada and the European Central Bank cut their policy rates in the first week of June.
It seems clear that the Bank of England and the Federal Reserve will follow suit in the coming months.
The financial markets have anticipated these changes for months in what turns out to have been a safe bet. The equity market is anticipating sustained economic activity and earnings once borrowing costs are reduced.
The money market is signaling stability. And while the bond market has retained a measure of caution, it has nevertheless reached a consensus on stability, the prospect of economic growth and higher interest rates.
The result is that our RSM US Financial Conditions Index turned positive in January and has centered at 0,25 standard deviations above zero since March, indicating the normal level of risk priced into financial securities.
Our index was designed to anticipate the willingness to borrow and lend and, in turn, the growth of the economy. As such, the easing of financial conditions has provided the groundwork for potential growth. In fact, our model for gross domestic product is anticipating real growth at an annualized rate of 2% over the next six quarters.
Rising confidence in business lending
The improvement in financial conditions can be interpreted as a vote of confidence in both the fiscal and monetary authorities.
Congress passed stimulus packages before austerity took hold and then found a way to fund budgetary requirements and our allies in distress. The Federal Reserve and the Treasury Department will always do what is needed to ensure financial stability.
The result is seen in the lowering of credit risk as the economic expansion takes hold and the risk of corporate default recedes.
A recovery in investment
We expect that after two years of tight monetary policy and inflation, there will be a reluctance to invest. In addition, it will take more than a few months to benefit from public spending on infrastructure and for the public-private investment in strategic industries to add to growth.
On a year-over-year basis, and excluding the distortions of the pandemic, the current recovery looks similar to previous business cycles.
The economy grew by 2.9% on a year-over-year basis in the first quarter, but this growth is relative to the slow pace of the first quarter last year when monetary policy put the brakes on the economy.
If there is to be a great difference in the recoveries, it is probably in the investments in equipment and intellectual property, both of which occurred early in the pandemic when interest rates were near zero.
These investments were likely factors in the recent rise in productivity that is likely to continue.
We should also note that there were distortions to residential investment during the pandemic, when households flocked to the suburbs and then pulled back as interest rates skyrocketed. Residential investment is accelerating once again, with the housing market unable to keep up with demand.
We expect that the private investment during the pandemic and the public-private investment from the fiscal stimulus will have long-term effects on the economy’s potential.
This is backbone of the pivot: a shift from an economy reliant on the import of cheap goods to an economy with greater self-sufficiency that makes full use of its technological advances.
A normalization of interest rates
The normalization of interest rates began before the emergency increase in the federal funds rate in March 2022.
Long-term yields had already moved away from the zero bound as sustained economic growth and a bear market in bonds became apparent.
By the end of 2022, 10-year yields were trading in a tight range of 3.5% to 4.0%. By the end of last year, when it became certain that the Federal Reserve would maintain its policy rate at an elevated level for as long as necessary to quash inflation, the 10-year yield settled into the 4.0% to 4.5% range.
Read RSM’s outlook on interest rates around the world from its global team of economists in the latest issue of The Real Economy.
We can see how this process worked out during the 2016-18 recovery from the financial crisis. As now, the bond market was quicker than the Fed in allowing yields to move higher.
As the federal funds rate was pushed gradually higher to 2.0% and 2.5%, the yield on 10-year bonds increased and settled into a range of roughly 2.5% to just above 3%.
The larger point is that because of the public investment in infrastructure and the private investments in productivity, it is more likely than not that 2% economic growth and price stability at the Fed’s 2% target will support interest rates at these higher, more realistic rates of return.
The flattening yield curve
We expect the first cut in the overnight funds rate at the Fed’s September meeting. That will eventually allow for a normal shape in the front end of the yield curve.
The middle of the Treasury yield curve from two years’ to five years’ maturity has been inverted since July 2022. The rate on three-month T-bills surpassed 10-year yields that October. Inversions occur when the Fed attempts to cool the economy by increasing short-term borrowing rates.
We expect two-year yields, which are proxy estimates of money-market rates in two years’ time, to drop rapidly once the Fed announces its first rate cut.
That should work to reverse the current spread between two-year yields at more than 4.7% and five-year yields now less than 4.3%.
According to the Fed’s projections for its overnight funds rate, and assuming that 10-year bonds stay above 4%, the front-end of the yield curve will flatten but remain slightly inverted until next year before taking its normal shape in 2026.
