The Decisive | Season 7 | Ep.5 - Frequently Asked Questions: Sovereign Yields, AI Productivity and the US Dollar

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Kristen Hallam   00:00:00

Sovereign bond yields AI-driven productivity and the direction of the U.S. dollar are all moving through an unusually uncertain macroeconomic environment. The Middle East conflict has added pressure through higher energy prices and inflation expectations, while questions about public finances, central bank policy, AI investment and currency movements are complicating the global outlook. So how should we understand the forces pushing sovereign yields higher, the debate over whether AI could eventually lower inflation and policy rates and what a weaker dollar could mean for the global economy. Those are the decisive questions today. I'm your host, Kristen Hallum, and I'm delighted to welcome Ken Watchrt, Vice President of Global Economics at S&P Global Market Intelligence, who sat down with me to address frequently asked questions on these topics. While our conversation was recorded in May, these questions remain top of mind today. So Ken, we have a specific question. But before that, could you briefly explain why sovereign yields have been rising since the conflict started?

Ken Wattret   00:01:28

Yes. There are lots of different macroeconomic reasons, which are leaning upon yields. First and foremost, higher inflation expectations. That reflects the direct effect of higher energy prices, but also worries about potential second round effects, input costs pass through into higher goods prices more generally. We've got some disruptions to supply chains, including for fertilizers, which could lead to higher food prices and so on. So there's a strong inflationary impulse, and that's not helpful for sovereign markets. And then related to that, there's been a big shift in monetary policy expectations. So there are some variations depending on the Central Bank we're talking about. In the case of the U.S., there's been a move away from pricing in a series of rate cuts this year to no change, some discussion of the possibility that interest rates in the U.S. may have to go up. In other parts of the world, particularly in Europe, we've moved towards a scenario where it's a question of how many times interest rates go up. So for the ECB and the Bank of England, futures markets are pricing in a series of rate rises and our forecasts are broadly aligned with those. And then the third element is the par state of the public finances and the potential cost of mitigation measures to cushion the energy shock. We've got major economies running persistently high budget deficits over a very long period of time and debt burdens have been rising. So not only does that limit government's room for maneuver in the short term in the event of bad news, but also it creates an underlying vulnerability. And it may well be that investors continue to demand a higher rate of return. in order to hold sovereign bonds given those underlying uncertainties. Now some of these factors may diminish if the disruption in the Middle East eases off and oil prices come down, those inflationary concerns will diminish. But there are still some underlying issues related to the state of the public finances, which are a constraint on how far sovereign yields could fall in that case.

Kristen Hallam   00:03:38

All right. Thank you, Ken. That's really good context to have as we get to the specific question, which is, why have sovereign yields risen more in the U.K. than in other G7 markets during the Middle East conflict?

Ken Wattret   00:03:54

Again, there are a lot of reasons why that's been happening, some macroeconomic, some more political in orientation. One is because the U.K. has really struggled to bring down inflation. We talked about the surge after the pandemic and the Ukraine conflict. The U.K.'s consumer price inflation rate peaked at over 11% in late 2022, and that was a few percentage points above the average for the G7 economies. And then if we look at the early part of this year, prior to the conflict starting, the U.K.'s consumer price inflation rate was still around 3%, again, about 1 percentage point above the G7 average. So there's less confidence that the U.K. can keep inflation in check without a series of interest rate rises, which is the second aspect. the prospect of relatively high levels of policy rates in the U.K. The Bank of England was quite cautious in cutting rates as inflation started to fall after the pandemic shock and the Ukraine conflict because inflation proved to be rather sticky. And so the Bank of England paused its easing cycle with policy rates a little below 4%. If you compare it to the European Central Bank, the policy rates are at 2%. So the U.K. had this inflation problem. That was reflected in the relative adjustment of Central Bank policy rates and markets are pricing in consistent with that, the likelihood that the Bank of England will start raising interest rates pretty soon, which we think makes sense. And then on top of that, you've got high budget deficit relatively elevated public sector debt ratio in the U.K., a government that's been struggling to meet its fiscal targets and has been announcing a series of adjustments to try and bring those targets back on track, which have made it increasingly unpopular. And there's a bit of history as well with the U.K. Obviously, we had a rather difficult period in 2022 when we had a very short-lived administration under Liz Trust that announced a series of kind of fiscal missteps, and that led to a sharp rise in gilt yields at the time. So there's a whole series of reasons why the U.K. market has been under more pressure, some fundamentally driven, some policy related, some about political issues. And many of these are likely to stick around. So if the conflict is generally leading to pressure on yields globally, it's quite likely that the U.K. would underperform in that regard.

Kristen Hallam   00:06:34

All right. Thanks for that, Ken. So we talked about AI's role in boosting global growth. Our next frequently asked question is AI related, but a little bit different. Will an AI-driven productivity pickup lead to lower inflation and Central Bank policy rates?

Ken Wattret   00:06:54

This is a source of considerable debate, particularly in the U.S. at present, and it might be helpful just to explain the context of that. There are 3 reasons why that's been quite prominent. First, because AI investment is expected to lead to a pickup in U.S. productivity growth. We've seen it to some extent. That's expected to carry on. Secondly, because there's a change in leadership at the Federal Reserve and the incoming Chair, Kevin Walsh, has been talking about the experience in the U.S. during the late 1990s when former Fed Chair, Alan Greenspan, kept interest rates low even though the economy growth-wise was booming at the time. And his reason for that was because he thought that productivity was pretty strong and inflationary pressures would stay relatively contained. And Kevin Walsh has cited that as a potential reason why interest rates -- short-term interest rates in the U.S. might fall. So that's the context. But then we need to think a little bit about the theory. And what's been interesting is that several Fed officials have expressed skepticism about the view that strong productivity will lead to low inflation and therefore, low central bank rates. And there are a few different reasons for that skepticism. One is quite a technical reason that if you do have sustained higher productivity growth, that raises the equilibrium real interest rate in the economy. And if that higher neutral level of real interest rates is in place, it actually implies a lesser need for the Central Bank to lower the policy rate. So that's a little complicated, but it's about where you think the neutral level of rate is. The second argument is that expectations of a pickup in productivity growth have been elevated for some time, and that's already reflected in very high levels of equity prices and pretty strong business investment in AI. And so this is about supply and demand. That's boosting demand, but we haven't seen the productivity gains fully realized. So the argument is that there's a rise in demand, but it hasn't yet been matched by supply, and that could prove inflationary. So that's also a reason not to be thinking about lowering interest rates. And the third aspect, which is more kind of a historical comparison is the Greenspan view in the late 1990s was very much that the Fed shouldn't rush into raising interest rates. But actually, after a short-lived period of easing from the second half of 1999, rate hikes recommenced in the U.S., and they continued through until mid-2000s. So there was a lag before the boom in growth fed through into inflation. But when it did, the Fed was tightening monetary policy pretty aggressively. The Fed funds rate at the time peaked at 6.5%. And that policy tightening actually contributed to the bursting of the dot-com bubble and a subsequent U.S. recession. So we need to be careful that we don't just take a selective slice of history. Yes, there was a debate at the Fed about high productivity, keeping inflation low. But actually, the Fed ended up raising interest rates quite significantly. And I think the thing to bear in mind currently on the inflation front is that the core PCE inflation rate in the U.S., which is the Fed's targeted rate, -- it's been above target for 5 years and by some distance. And it's likely to get higher because of the energy shock that we've been talking about. So the context here is quite challenging. So there is a wider question that if the Fed does pursue lower policy rates under the new leadership, is that merited on the basis of inflation prospects? And I think this issue is going to run and run.

Kristen Hallam   00:10:46

Lots to think about there. I expect this debate will not go away. So Ken, what indicators do you look at to clue you in on what may be happening on the AI and productivity front?

Ken Wattret   00:11:03

This one really depends on the economy that we're talking about. There are official data that we can monitor for AI-related investments. They're particularly detailed in the U.S., but in many other economies, we don't have that granular level of detail in the national accounts. We see still very strong growth in AI-related investment in that data in the U.S., the share of equipment, software spending and so on as a share of overall GDP has risen well above its highs prior to the dot-com bubble bursting in 2000. So you can really see it in that ratio. It's not just the growth rate, which has been exceptionally strong, but the share in GDP has also been rising. Now productivity data, they are available on a regular basis, but they tend to be quite volatile and they tend to be subject to revision. So that's one of the constraints there. There are lots of other AI-related indicators that we're looking at, many of which we produce here, could be rates of AI adoption, could be investments in data centers and so on. So there are lots of different aspects of data that we need to look at. But it's one of those areas where the official data only takes you so far. And it's important to actually that aspect in relation to the issue of U.S. productivity growth, inflation and what the Fed may or may not do because back in the second half of the '90s when the former Fed Chair, Alan Greenspan was talking about that productivity boom, he was relying very much on anecdotal evidence in favor of that view. And that's something that Fed Chair, Kevin Walsh has also talked about. So this is one of those areas where it's a much wider range of indicators that typically will influence the debate rather than just the official data that are available.

Kristen Hallam   00:12:56

All right. Ken, let's wrap up with a couple of questions on the U.S. dollar. Why has the U.S. dollar declined so sharply? And will it continue?

Ken Wattret   00:13:07

I think the short answer to will it continue is we think it will if fundamental drivers are dominating currency markets. And that then brings us back to the uncertain environment related to the Middle East conflict because typically, when there's a lot of uncertainty and financial market volatility, there are safe haven inflows in favor of the dollar. And we saw some of that earlier this year. So if we go back a step and look at when the dollar was falling, in the year prior to the start of the Middle East conflict in late February, the broad nominal effective U.S. dollar index. That's quite a mouthful, but that's the trade-weighted dollar, that fell by about 10%. 10% is a big move. It then rebounded from late February when the conflict began because of those uncertainties and the safe haven flow. So during March, the dollar index rose by about 3%. So that's a partial reversal of its previous depreciation, not a full reversal. And then subsequently, those gains have largely unwound. Currency movements are notoriously difficult to predict and explain, but there are some various fundamental factors, which were leaning down on the dollar during 2025 and early 2026 and which favor a resumption of the depreciating trend. Now one is the level of the dollar on all measures, on a trade-weighted basis, the dollar is still relatively strong. And so therefore, if you think that currencies revert to the long run average over time, then that would incline you to think that the dollar might continue to depreciate. And then there are a couple of other factors. One is that the U.S. still runs very large persistent trade and current account deficits, and they are typically commensurate with the currency being overvalued and needing to adjust downwards interest rate differentials, which are a particularly important driver of exchange rates, they are expected to narrow. They're expected to go against the U.S. dollar. So put those together, we're expecting that the dollar depreciation trend will resume. It's expected to be relatively gradual, and we have to be cognizant of the fact that it could be very bumpy because we've got all kinds of uncertainty going on at the moment and lots of different influences on the dollar. But if it's fundamental grounds that we're looking at, we think the dollar probably has further to fall.

Kristen Hallam   00:15:32

If there's one word that sums it up, I think bumpy is it, Ken. So what does this trend mean for the global economy?

Ken Wattret   00:15:40

Actually, in one respect, it might be quite helpful, and that relates to the energy shock. So countries that are battling against higher energy prices don't want their currencies to decline because that adds to imported inflationary pressures, and it adds to the pressure on their central banks to raise policy rates to try and keep inflation in check. So if the dollar is coming down, and other currencies are appreciating, that leans against those inflationary pressures, and that might help to limit the need for widespread policy rate rises, and that can help to avoid a hard landing for the global economy and problems in financial markets. When it comes to the impact on the U.S., it's mixed really. It would add to inflationary pressures at an inopportune time because U.S. inflation has been above the Fed's target for quite a while and there's the direct effect of the energy shock still to come through. So that's not helpful. It may incline the Fed away from the interest rate cuts that are still being priced in for 2027. The speed of the fall is also important. If there's a gradual decline in the currency, it's probably not that big of a worry to the Fed. They're probably looking at other influences on inflation as being more important. But if the dollar were to fall quite steeply, then that is potentially a problem for inflation.

Kristen Hallam   00:17:06

Thank you for listening to the decisive podcast from S&P Global. Please be sure to subscribe so you never miss an episode. Until next time. Thank you for listening to The Decisive Podcast from S&P Global. Please subscribe and join us for next week's episode. Until then, stay curious and stay informed.