Oct. 31, 2016 1:58 p.m. ET
Appearances can be deceptive. The two big market moves in October were a vicious bond selloff and the dollar’s rise back to where it started the year, and neither tells the obvious story.
On the face of it, a stronger dollar and higher bond yields suggest the U.S. is getting its mojo back, after a rough year. Having started the year with a consensus forecast for U.S. economic growth of 2.5%, the dollar and bond yields plummeted as investors marked down global prospects. Perhaps a reversal of those moves will let moderately better times—if not actually good times—roll.
Unfortunately there’s more going on, and it suggests moderately bad news. What’s being priced in is higher inflation without much in the way of growth. That’s bad for consumers, who will pay higher prices, bad for companies, which will struggle to expand sales, and bad for investors, as it hurts the price of both bonds and equities at once.
The rise in inflation expectations is clear. The average U.S. inflation rate over the next 10 years priced into bond markets is at its highest level this year, having risen from 1.55% at the start of January to 1.74%. The rate for the five years starting in five years’ time, designed to strip out short-term moves such as oil-price swings, is also at a new high for the year of 1.84%, after dipping to 1.4% in both February and June.
Growth expectations are trickier to measure, but should show up in the yield on inflation-protected Treasurys, or TIPS, which is automatically adjusted for inflation. A stronger economy ought to mean demand for money outstrips price rises, pushing up yields. Yet, the real 10-year yield has barely recovered from lows hit in early July, after the U.K.’s vote to leave the European Union roiled markets. Having started the year offering 0.72% above inflation for 10 years, TIPS now offer just 0.12%.
Softer growth is forecast by economists, too. The regular survey by Consensus Economics last month had this year’s expansion down from 2.5% at the start of the year to 1.5%, while 2017 growth predictions dropped from 2.4% to 2.2%.
Other measures fit the forecast. Equities and bonds have been selling off together, with the 60-day correlation between the two the highest in a decade. This makes sense. In the past two decades shares and bond prices have been negatively correlated, tending to move in opposite directions on any given day. That’s because inflation is bad for bonds, but its drag on equities has often been offset when the inflation is caused by a stronger economy.
It’s possible that something else is going on. Some investors think the rising yields are really just a correction of the frothy bond market of the summer, when prices soared and yields hit record lows. Others point to the U.S. presidential campaign, with bond yields rising and falling with the latest headlines.
Cause and effect are hard to disentangle, but inflation expectations are rising as commodity prices bounce back. As with the equity-bond correlations, it looks like the usual link between a stronger dollar and cheaper commodities is broken. Instead of falling as the dollar strengthened recently, prices of industrial metals last week and crude oil in mid-October hit their highest since July 2015.
This breakdown in the dollar’s usual relationships has helped to shield emerging markets from the turmoil often associated with a stronger greenback in the past. Indeed, this year several emerging commodity exporters have had stunning gains in their currencies, with the Brazilian real up 25%, Russian ruble up 15% and South African rand up 14%. Weakness in China’s yuan means the dollar is up a little on a trade-weighted basis against emerging currencies this year, but it’s at the same level as in June.
Markets can be wrong, and often are. An inflationary, slow-growth America would not be a great outcome. But just a few months ago investors were worrying about an even worse result, the danger of deflation.
There’s bad news either way: The obvious investments offer miserable rewards. Treasurys offer the best protection against deflation, but the 10-year still yields just 1.84%. TIPS offer the best protection against inflation, and yield only 0.12%. Making money in a low-growth world is hard.
Write to James Mackintosh at James.Mackintosh@wsj.com
Tags: bond selloff, Britain, China, China's economy, deflation, dollar’s rise, European Union, inflation, long-term growth, market moves, selloff in bonds, Softer growth is forecast by economists, TIPS, U.S. economy, UK, weak growth