(Bloomberg View) --
This week, the U.S. became the latest advanced economy to experience a decline to record levels of the yield of its benchmark 10-year government bonds, along with a continued flattening in the yield curve for its Treasury securities.
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But the traditional drivers can't explain these developments. That also means the signals being transmitted to markets and the implications for the economy and policy can't be analyzed in the usual way. Instead, here are three major takeaways from these unprecedented circumstances.
This notable decline in Treasury yields is not following a conventional path, particularly as it says a lot more about Europe and Japan than about the U.S.Traditionally, lower yields and a flatter yield curve in the U.S. are strong signals of an approaching recession -- and, in this particular case, they would be signaling a painful downturn, given how far yields have dropped and how flat the curve has become.Yet that reading doesn't apply in this case: Rather than being driven by U.S. conditions, the Treasury yield curve has been captured by developments in Europe and, to a lesser extent, Japan -- specifically, the prospects for yet another economic slowdown and the likelihood of additional central bank stimulus (including lower rates in the U.K. and an expansion of the European Central Bank’s large-scale program of security purchases). Concerns about sluggish growth abroad have been amplified in recent days by the outcome of the Brexit referendum, which adds unusual institutional uncertainties to already fragile economic conditions, a fluid financial situation and an imbalanced policy stance that is over-reliant on central banks.
The aftermath of the U.K. vote to leave the European Union is correctly predicted to lead to lower business investment in Britain and more muted consumer confidence. Although the injection of liquidity by the Bank of England and the easing of banks’ reserve requirements could act as a moderating force, the impact will be marginal. The proposal to cut the corporate tax rate by Chancellor of the Exchequer George Osborne will have even more limited beneficial economic effects, though it will complicate negotiations with the EU and fuel concerns that the “political establishment” is again favoring the “business elites.” Lower U.K. growth will have unfavorable spillover effects on the rest of Europe. This will be compounded by the constraints placed on economic policy by the destabilizing effects of anti-establishment movements, despite the buyer’s remorse that followed the Brexit vote.The good news for Americans is that the negative spillover from lower growth in Europe is likely to be limited. The U.S. is still in control of its economic destiny, though there is little to be done about the yield curve. As negative rates in much of Europe make U.S. fixed income assets even more appealing to bond investors around the world, the resulting decline in yields and the associated flattening of the curve will far exceed what is warranted solely on the basis of U.S. economic and policy prospects.
The beneficial impact of lower yields on the economy will be limited, and could even be offset by financial considerations.The lower interest rate configuration throughout the advanced world is unlikely to provide much of a boost to economic activity. Most importantly, it does little to address longstanding structural headwinds, which, in recent days, have been compounded by uncertainties about the future of the U.K.’s trade and business relations with the rest of the European Union.
Yet the changes in yields will impose even more pressure on the banking system by darkening the prospects for earnings and profit. This is particularly worrisome for European banks whose recovery process has lagged that of their U.S. counterparts, and for whom the credit quality of loan portfolios will be affected by the economic slowdown.The lower yields will also amplify worries about excessive risk taking by non-banks. As they try to meet unchanged -- and increasingly unrealistic -- objectives, investors are likely to stretch even further for financial returns, increasing the risk of financial instability down the road.
This will further complicate the challenging task facing Federal Reserve policy makers.None of these developments will come as good news to the Fed, which is already carrying an excessive policy burden.In addition to making interest rate decisions more complicated -- including whether to hike this year -- recent developments are likely to accentuate worries about the ability of macro-prudential policies and the regulatory apparatus to counter the mounting challenges to future financial stability and economic well-being.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
