You can dance until the music stops
For the markets in Europe and the U.S., the following developments are currently the most relevant:
- Excessively large government deficits. Politicians are too divided to implement measures that would bring these deficits down quickly.
- At the same time, there is a boom in AI-related investments, which is driving high demand for capital.
- Inflation is under upward pressure due to rising energy and food prices. Furthermore, the tight labor market could easily lead to higher wage increases.
- Relatively high economic growth, despite rising interest rates and energy prices. This is due to large government deficits, the investment boom, and a significant positive wealth effect.
- The factors mentioned above are creating further upward pressure on long-term yields.
For the financial markets, it is crucial to determine how high interest rates will rise in this environment. Likely just as long and as high as it takes for something to snap, probably in the form of sharply falling stock prices and/or slowing economic growth. This is not yet the case, but how much longer can it last? The following must be kept in mind. Normally, interest rates on government bonds with longer maturities are very close to the economy's nominal growth rate. Only when they rise significantly above that level can we speak of a restrictive monetary policy.
The first question that must therefore be asked is: what kind of monetary policy should be pursued now: loose, neutral, or tight? The answer to this question lies in the following.
Energy and food prices have risen sharply, which, given the current relatively high growth (particularly in the U.S.) and the tight labor market, could easily lead to so-called "secondary effects." Higher inflation would then take on a more structural character.
To bring inflation back under control, economic growth would then need to be kept below "potential growth" for a period of time. This is the sum of the growth in the labor force and the increase in productivity. In the U.S., this figure stands at approximately 2.5%, and in Europe at approximately 1.25%. Economic growth must therefore be brought down to these levels, but it currently stands at approximately 3.5% and 1.5%, respectively.
This means that a restrictive monetary policy must be pursued in both the U.S. and Europe. However, with nominal growth of approximately 6% and approximately 4.5%, respectively, and current 10-year yields of approximately 5.3% and approximately 3.5%, this is not yet the case. Rather, the policy remains accommodative or, at best, neutral. For policy to become restrictive, interest rates must therefore rise even further. The markets are already pricing this in to some extent.
The only question is: are the markets currently pricing in too much or too little of an interest rate hike? There is no clear answer to this, because interest rates will continue to rise until something "breaks." This could take the form of data clearly pointing to slowing growth and/or a decline in stock prices. Both are clear signals that monetary policy is restrictive.
It can be argued, however, that if oil prices and food prices were to fall, nominal growth and inflation would decline, meaning interest rates would need to rise less than is currently priced in. If energy and food prices continue to rise, the opposite would be true. Hence the current close correlation between oil price movements and long-term interest rates.
We, for our part, assume that the probability of a decline in energy and food prices is well below 50%. If we are proven correct, this will be negative for stock prices and the gold price, and positive for the dollar relative to the euro. After all, the U.S. needs a tighter monetary policy than Europe.
