One of the key question in financial markets is whether the 30-year Treasury bond market rally has come to an end and that recent below-average yields (of < 2% in past two years) will rise back to more 'normal' levels that reflect America's new economic outlook of slightly firmer GDP growth and moderately higher inflation.
In another words, will America be emerging into a new era of 3% real GDP growth in the next two years after struggling at the 2.2% average level in the post-recovery period of 2010-2013?
This is what the consensus of economists are expecting at present due to various reasons such as the cheap gas effect, housing market recovery or narrowing fiscal deficit. As we enter into the second half of 2013 and as the markets attempt to build up expectations of the outlook for 2014, more economists may converge to that view.
In my view, they are either driven into that bullish consensus due to the buoyancy of the U.S. stock market, the upward trend in the U.S. dollar or simply because the Federal Reserve is allowing the 10-year Treasury yield to rise slowly suggesting to market players that the deflation era is over.
But if that is the case, then this recovery is an odd one: inflationary pressures are benign, global demand is sluggish and the U.S. consumer is not spending in any big way apart from a steady 2% real growth year-on-year.
My guess is that real GDP growth will surge towards 2.5% in 2014 and then regress back towards the 2% level again by 2015.
The Treasury market is harder to predict especially when there is a big government propping up the market. Treasury yields can either (a) rise towards the 3-4% level if inflation moves higher in a stagflation scenario or (b) remain trading at the 2% level if the Fed continues to buy Treasury bonds to keep yields low.
From an financial strategist perspective, there are three strategies that can be adopted: (1) reversion to the mean (2) carry trade (3) momentum. The Fed's easy monetary policy has caused the US$ to be an instrument of carry trades whereby investors borrow cheaply in US$ to buy foreign assets that fetch higher yields (e.g. emerging markets, Japanese stocks, etc).
But the Fed's QE policy is also preventing the Treasury market to revert back to the mean. Thus, the carry trade will induce greater imbalances in the economy as consumption and investment is driven more by asset prices than by real savings.
At the end of the day, even financial markets have to revert back to the mean as prices cannot go up continuously (witness Japan). Hence, momentum will build up, weaken and then reverse in the other direction until the central banks come in to support asset markets again.
This is the conundrum for global central banks: how to exit gracefully from their easy money policies without disrupting financial markets? If they are confident that their economies are able to stand without the clutch of artificially low interest rates, then they should have no hesitation in slowly scaling down their QE policies or allowing interest rates to normalise.
But the latter may not be the case as global banks still have lots of leverage and low quality assets on their books. So if the central banks' hidden mandate is to save their leveraged banking system (which is much the case in Europe), then we will be stuck with QE to infinity: an era of high market volatility and uneven economic growth.
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