In Macro Matters, a new series for the PIMCO Blog, global economic advisor Joachim Fels offers analysis on macroeconomic developments and their market implications.
Recent data including last Friday’s labor market report portray an improving U.S. economy, implying that the Federal Reserve is inching closer to a first rate hike before year-end. While the short end of the bond market seems to agree, longer-dated yields have been living a life of their own, with 10-year yields down some 35 basis points (bps) from their early June peak of 2.5%. As a consequence, the two- to 10-year yield curve has flattened by no less than 30 bps. What’s going on?
One possible explanation is that the bond market believes the Fed is about to make a hawkish mistake. However, how can a 25 bp rate hike, which would hardly be surprising by the time it arrives, derail a $17.84 trillion U.S. economy, especially if it is accompanied by plenty of “gradual path” reassurances?
A more plausible explanation for the strange behavior of the U.S. yield curve is that while the short end is naturally driven by the Fed outlook, the intermediate and long end are driven mainly by global factors – in particular the global savings glut (see my August Macro Perspectives, which details a “three gluts” framework).
What is likely weighing on U.S. and other developed market bond yields is the mounting challenge facing emerging market economies: Declining/increasing EM capital imports/exports are adding to a global savings glut. China’s current account surplus has been increasing year-to-date compared with last year, as has Russia’s external surplus, while Brazil’s current account deficit has been shrinking rapidly. In all three cases, this reflects weaker imports due to domestic economic issues. As a consequence, China and Russia are now even bigger net exporters of capital and Brazil is a smaller net importer. In addition, China’s decision last night to depreciate its currency will likely encourage even more capital outflows from China.
Similar stories can be told for many other EM economies, with the net result that more capital stays in or returns to developed markets, depressing bond yields and supporting the prices of other DM assets. So, to get a sustained rise in longer-dated DM yields, we first need to see EM turning the corner and start absorbing rather than adding to the global savings glut. (Don’t hold your breath.)