Thursday, July 14, 2016

"How a Surprise Upturn in U.S. Growth Could Trigger the Next Recession"

From Real Time Economics:
Some economists, including a former top IMF official, warn market expectations for weak growth could spark financial turmoil

Could the cause of the next U.S. recession be too much growth? That is one risk of an unprecedented environment in which investors are betting heavily on a perpetually weak economic expansion.
If markets are wrong–and the economy surges instead of sputters–the bad bets could roil the financial system, some economists are increasingly warning.

“Ironically, one can think of a scenario where a stronger-than-expected expansion leads to financial trouble, which in turn puts into question the expansion itself,” said former International Monetary Fund chief economist Olivier Blanchard.

Mr. Blanchard is the latest prominent economist to warn that a surprise upturn in growth may force the Federal Reserve to raise rates faster than investors expect. A jump in borrowing costs could catch many off guard, given that much of their portfolios are based on lower rates.

“If the economy were to pick up faster than markets think, which I think has substantial probability, it could lead to some financial turmoil,” Mr. Blanchard, now a senior fellow at the Peterson Institute for International Economics, said in an interview.

June’s strong jobs numbers helped tame growing fears of a U.S. contraction. Many investors see a major compression of the yield curve on U.S. treasuries—the difference between near-term and long-term government interest rates—as signaling an imminent recession.

But if employment, wages and inflation rise at a speedier clip than many investors currently forecast, it could cause an economic hiccup as the yield curve decompresses.

“I suspect that some investors with long bond positions would find themselves in trouble,” he says.

A rapid decompression of the yield curve would not only make credit more expensive. But the resulting plummet in bond prices would erase vast amounts of value off investor balance sheets. It could also create major bottlenecks in the financial system, especially since bond markets are so crowded. And it could also have global repercussions: A jump in U.S. rates would likely spur send yields higher across the world, where investors are holding trillions of dollars worth of sovereign bonds with negative rates....MORE
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