A Narrower Path for Growth and Stability

Arunima Sinha · Morgan Stanley

Neutral rate likely higher; given rate level less restrictive as productivity and investment rise.

Economists judge rates against the natural rate. Stronger productivity growth and investment demand should raise the natural rate, so a given level of rates is less restrictive. Long-term Treasury yields are rising alongside still-firm growth and earnings expectations, which indicates the neutral rate may indeed be higher. When yields rise because growth prospects improve, expected returns and capital demand rise, so higher rates are not necessarily contractionary. Activity concentrated in innovation, productivity and strategic-investment sectors may make the economy less rate-sensitive than in past cycles, and that contrast is becoming more apparent. The benign reading is contrasted with a less benign one in which yields rise because inflation is hot and fiscal concerns intensify.

“Stronger productivity growth and investment demand should mean a higher natural rate, so a given level of rates is less restrictive.”at 1:27

Arunima Sinha · Morgan Stanley

Latest upside inflation surprise reflects resilient demand, not energy-driven stagflation.

Even the most recent upside inflation surprise pointed to resilient demand rather than energy-driven stagflation. The simple explanation is that many firms still see returns well above their cost of capital, so they keep investing and spending despite higher rates. Recent work from the US economics team supports this view.

“Even the most recent upside inflation surprise pointed to resilient demand rather than energy driven stagflation.”at 2:25

Arunima Sinha · Morgan Stanley

Widest spread widening in lowest-quality credit shows US financial conditions are restrictive.

The biggest spread widening is occurring in the lowest-quality part of the credit spectrum. Housing activity is also at recessionary levels. Together these are signs that US policy and financial conditions are restrictive, which weighs on the debate over whether the Fed has less work to do because financial conditions have already tightened.

“The fact that we're seeing the biggest spread widening in the lowest quality part of the credit spectrum and the fact that housing activity is at recessionary levels are some tells in The U. S. that policy and financial conditions are restrictive.”at 3:08

Arunima Sinha · Morgan Stanley

Financial conditions are tightening more visibly in Europe than in the US, with growth not offsetting fiscal worries.

Signs of tighter financial conditions are more visible in Europe, partly because AI capex spending is a smaller factor there than in the US. Growth has been resilient but not sufficiently so to offset rising fiscal concerns stemming from higher rates. The French bond sell-off shows how quickly the balance of risk shifts, and globally financial conditions are introducing tougher conditions to the macro landscape.

“The signs of tighter financial conditions are somewhat more visible in Europe, in part because the AI CapEx spend is less of a factor.”at 3:24

Arunima Sinha · Morgan Stanley

Yields rising through real rates, not breakevens, means markets see policy tightening to cut growth.

As the rates strategy colleagues have noted, inflationary pressures have pushed up real rates rather than breakeven inflation. Yields have also risen because inflation has been hot, fiscal concerns are intensifying, and investors are demanding more compensation for holding duration. The market is therefore signalling that policy is getting tighter to restrain growth and eventually pull down inflation.

“Inflationary pressures have pushed up real rates, not break evens. So the market is telling us that policy is getting tighter to restrain growth and eventually pull down inflation.”at 4:10