When it comes to financial markets, nothing is certain. For much of the last few decades, however, it was easy to convince yourself otherwise: Interest rates mostly went in one direction, down, and high inflation was a thing of the past.
The pandemic economy, and the policies in response to it, changed all that. Not only did they bring back higher inflation and interest rates, they also altered expectations. And while the consensus is that the US economy will stick a soft landing, there is wide variation among investors, consumers and professional forecasters about future inflation rates and bond yields.
The upshot is an economy with more uncertainty — and a healthier relationship with risk.
Torsten Slok, chief economist at Apollo Global Management, published a chart last month showing that, for the first time in years, there is a wide range of opinions among forecasters about the 10-year bond yield over the next 12 months. Some expect rates to be less than 3% next year, others more than 5%. Since then, expectations have converged a bit, but they are still elevated.
The survey also shows more disagreement about the future of inflation, as do surveys of consumer expectations.
On the one hand, this seems like a troubling development: More uncertainty in markets can be destabilizing and hamper economic activity. Uncertainty about future bond volatility and inflation can increase the premium on longer-term debt and the price of capital. And when it comes to inflation and bond premiums, expectations are often self-fulfilling: People demand wages and set prices that align with their inflation expectations. When there is more uncertainty, a spark of high inflation or an increase in bond prices can further destabilize expectations. One of the Federal Reserve’s most powerful tools is setting expectations, and if they are all over the place, it suggests the Fed is not doing its job very well.
All of this adds up to a more risky and less certain environment.
On the other hand, the increased dispersion might be a sign of a humbler and healthier relationship with risk. Yes, expectations are powerful, and they can be self-fulfilling, but not always. How common is it for everyone to agree that the economy is heading to a specific place, or an asset is worth a specific amount — only for a big shock to come along and prove us all wrong?
Few people in 2019 expected high inflation was imminent, for example. You can argue that no one could have predicted Covid-19, or the subsequent $6 trillion in federal spending to address it, and you would be correct — and that’s my point. Now, even as inflation and interest rates continue to moderate in the short term, there are reasons to expect them to be higher in the future.
Again, the point is that no one really knows — and in a more uncertain world, a wider range of forecasts is better than near-unanimous agreement.
That’s true not just because more agreement means there are more people who could turn out to be wrong. It’s that this certainty, bolstered by consensus, can lead people to take on more risk. They might not even hedge or insure.
This kind of groupthink can expose not only investors and consumers, but also governments. Debt levels are expected to rise to historic levels in the coming decade. When market forecasters agree that rates will never go up, it can give policymakers a false sense of comfort they can create new entitlements without worrying too much about how to pay for them.
The truth is that the market will tolerate very high levels of debt — until it doesn’t. When it changes its mind, things can get pretty ugly pretty fast.
A lack of consensus on the direction of macro variables also means there is less pressure for intellectual conformity. If everyone expects 10-year rates to be 3% and inflation rates to be 2% next year, it is harder to be the lone voice forecasting something different. It is one thing to be wrong when everyone else is, too. A contrarian who is proved wrong may end up losing both their reputation and their job. A greater diversity of opinions on Wall Street — like a greater diversity of opinions in academia — can bring about a richer discussion, helping to expose previously unseen risks and weaknesses.
In the last few weeks, the promise of falling inflation and Fed rate cuts has narrowed the range of forecasts. Like other macro variables, they appear to be heading back to normal. It is possible, then — but far from certain — that the US is returning to something like the 2019 economy. The greatest risk facing the economy right now, in fact, may be the growing consensus about where it’s headed.
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