Horizon’s Chief Global Strategist

August 7, 2018

The Case for Lower Interest Rates

WHEN JAMIE DIMON PROCLAIMED ON SATURDAY that the 10-year Treasury bond yield could hit 5% “or higher” in the next couple of years – joining a chorus of alleged experts who see much higher rates – it got us thinking about a contrarian scenario: what if rates stay where they are or even fall in the next few quarters? There’s a plausible case for that scenario.

THE GREATEST VARIABLE is the extent of the trade war, and it sure looks like China will not be bullied and is prepared to weather lower economic growth and a turbulent stock market. There’s a fair chance that NAFTA can get resolved, there’s a fair chance that U.S. relations with the EU will improve by year-end, but there’s little prospect of a quick deal with China; both sides are miles apart, and U.S. relations with Beijing could deteriorate further.

SO THE BIG QUESTION IS WHAT THAT WOULD MEAN for the U.S. economy and the Federal Reserve. An all-out trade war might add a few tenths of a percent to the inflation rate, but perhaps the bigger fear is that it would begin to slow economic growth everywhere. Could businesses leaders slow down their plans to invest and hire because of uncertainty over tariffs? Based on what we’re hearing, they already have.

THERE’S SO MUCH MOMENTUM AND FISCAL STIMULUS in the U.S. economy right now that another strong quarter is likely; third quarter growth of close to 4% is possible – but what if that’s the peak? What if signs of a hiring slowdown become clear by the fourth quarter because of a deepening trade war?

THIS HAS TO CONCERN FED CHAIRMAN JAY POWELL, who has essentially promised a rate hike on Sept. 26, and he’s leaning toward another hike on Dec. 19, assuming the data warrant it. But what if economic growth is showing clear signs of moderating by the first quarter? (And, of course, the first quarter always seems to surprise to the downside.) It’s possible that the uncertainty could prompt the Fed to slow its tightening plans for 2019.

MUCH OF THIS HINGES ON CHINA: It’s possible that officials in Beijing will cry uncle, but our sense is that they will not accept bullying; appearances matter to the Chinese. If they’re prepared to accept lower economic growth, that could infect other economies – including the U.S. economy.

WITH ALL DUE RESPECT to Jamie Dimon, it’s difficult to see the 10-year yield spiking to 5% under this scenario. If 10-year rates can’t get past 3% in the current red hot economy, what might happen if growth is softening by Christmas?