US and Europe

Bond market risks to global economic outlook

Monday February 12, 2018 Julian Williams

“Brighter prospects, optimistic markets, challenges ahead” is the headline of the 22 January release of the World Economic Outlook by the International Monetary Fund (IMF). Global growth forecasts for 2018 and 2019 have been revised upward from the previous quarter by 0.2 percentage points (pp) to 3.9 percent. Half of the 0.2 pp comes from expected economic stimulation from United States tax policy changes, raising United States real gross domestic product 1.2 percent by 2020, with increased imports and a widening current account deficit.


The IMF expects “brighter prospects and optimistic markets” to last only to 2020. From there we are left with the “challenges ahead”. The IMF observes that the increased fiscal deficit of the United States will “require fiscal adjustment down the road”. Further, the predicted benefits from the tax changes are transitory. As a result, growth is expected to be lower than in previous forecasts from 2022 onward, offsetting some of the earlier growth gains.


From 2020, future growth in the United States and by implication global growth, according to the IMF, needs: (i) inflation to be “muted” by Federal Reserve policy rate increases and (ii) the yield gap between policy rates and long term bond rates (10 year say) to increase only a little. The IMF calls this latter proviso “modest decompression”. Another proviso is low United States dollar appreciation so that increases in imports and falls in exports are mild, and consequently so, increases in the annual current account deficit.


The IMF says the biggest risk to this scenario is “larger decompression of risk premiums”. This means a larger yield gap, which would prelude a shakedown of global bond markets and most other asset markets as well, as bond yields rise strongly and bond and other asset prices fall sharply. Potentially, it could start with higher domestic demand in the United States (remember – from the pre-2022 brighter prospects and optimistic markets) fuelling price and wage inflation (in a tight labour market) and raising expectations of future long-term interest rates (nominal and real). 


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It could be exacerbated with the Federal Reserve raising short-term policy rates to dampen inflation. The IMF hints that this scenario could mean financial distress for economies (we presume they are mindful of the United States) with high gross debt refinancing needs and unhedged dollar liabilities. Keep watching the bond markets as the United States gradually rolls out increases in policy interest rates.