2023 Summer Brings Bond Market Reckoning and Turmoil

Former Treasury Secretary Lawrence Summers warned that the assumption that the bond market has made, that the era of low interest rates is coming back, is likely to be wrong. He said that this assumption is based on the idea that there will be disinflationary pressures, but he does not believe that this is the case.

In an interview with Bloomberg Television's "Wall Street Week," Summers said that he suspects there will be market turmoil in 2023. He explained that this year will be remembered as a "V" year, during which it became clear that we are entering a new financial era with different interest rate patterns.

A number of indicators in the bond market, as well as long-run projections from the Federal Reserve, suggest that the same drivers that held down inflation before its recent surge are expected to return, Summers said. These drivers include:

Summers said that the assumptions about secular stagnation and low interest rates are likely to be wrong. He pointed to the example of those who predicted that the economy would return to these conditions after the Second World War, but were proven wrong.

Summers argues that the pre-Covid secular stagnation pattern is unlikely to return. He points to a number of shifts that suggest this.

Fiscal deficits and the government debt load are likely to continue to increase, thanks in part to expanded spending on national security. Investment outlays are also likely to be stronger, with the efforts to bring production back to the US and increase resilience in supply chains. The global "green-energy transformation" will also help mop up savings, according to Summers.

The dynamic of workers from China and other emerging markets joining the global economy has now run its course, according to one economist. This has served to depress price pressures, but with increases in uncertainty, investors are now demanding higher premiums for risk.

Olivier Blanchard, former IMF chief economist, has argued that three key drivers of low rates are likely to remain in place going forward. Demographic trends mean that savings rates are likely to remain high, and there’s probably still going to be strong demand for the relative safety of government securities, he argues.

Even if a large-scale investment in green technology to combat climate change were to lead to higher interest rates, Blanchard (a senior fellow at the Peterson Institute for International Economics) still believes they would remain relatively low.

Summers believes that the forces of secular stagnation are strong, but ultimately believes that the orthodox view will be proven incorrect.

Looking at the December US jobs report, the former Treasury chief said that the slowdown in wage growth was encouraging. The strength in employment growth indicates that a US recession is not imminent.

"I think the judgment that soft landings are the triumph of hope over experience is still the best guess," he said. "I'm not sure that continued strength points to a softer landing, rather than pointing to an even harder landing when things re-equilibrate."

Summers reiterated his praise for Fed policymakers’ hawkish shift over the past several months. He also repeated that the central bank should follow through on its signals of raising rates further and keeping rates high for some time to quell inflation.