Goldman’s O’Neill: Economy Getting Back to ‘Normal’

What could go wrong? A stampede out of bonds if everyone agrees

Goldman Sachs Asset Management Chairman Jim O’Neill says U.S. markets show signs of a return to normality. Goldman Sachs Asset Management Chairman Jim O’Neill says U.S. markets show signs of a return to normality.

The U.S. markets keep showing signs of returning back to normal, says Goldman Sachs Asset Management Chairman Jim O’Neill in his latest note, pointing to “breakouts” including positive jobs data three months in a row, the S&P 500’s rise above 1,400, a drop in gold prices and, particularly, good news from the Federal Reserve.

In short, U.S. stocks are going up while bonds are going down, and all is well in creation.

“Whisper it, but in addition to many things developing the way I had expected, the markets are showing some signs of a return to normality,” O’Neill wrote on March 17 in The Beginning of a Return to Normal? “Probably a most important development for the change in correlations, U.S. bond prices fell as market participants reassessed the profile of the Fed’s future monetary policy.”

O’Neill followed his positive assessment with the warning that the greatest risk to U.S. markets would be a stampede out of bonds if investors suddenly agreed en masse that the economy was indeed back to a state of normalcy.

“Of course, one has to be on the lookout for all of the things that could go wrong, of which there continues to be no shortage," he wrote. "Amongst these potential pitfalls are the implications for bond markets if everyone suddenly decided that, indeed, the U.S. (and Fed policy!) is returning to normal.”

O’Neill said the Fed in its last two meetings has revealed plenty about its monetary thinking. Presumably, he said, normalcy involves a federal funds rate in the vicinity of 3.5% to 5%. A jump in two-year note yields from the low 0.20% range to about 0.40% this past week signals “a true shift in confidence,” he said.

“Indeed, the consequences could be so great, in terms of tightening financial conditions, my belief is that the Fed will keep a strong asymmetry to their policy bias for quite some time until they are convinced that an economic recovery is in place,” O’Neill said, adding that the Fed may allow all rates to ramp up higher at some point.

For most markets, "ultimate normality" is a long ways away, he said, conceding that a fed funds rate of 3.5% to 5% is consistent with 10-year bond yields at least 200 basis points higher than they are now.

Still, the Goldman asset management chairman started to feel bullish about the United States in late 2010, and if anything, his confidence is growing stronger.

"There are increasing signs, in my judgment, that the U.S. is returning a bit more to normality (not the least of which are higher-than-expected trade deficits),” O’Neill said. “There continue to be both positive anecdotes about the confidence of domestic business and, critically, the housing market. The performance of U.S. financials continues to improve. This probably reflects aspects of the trends in business confidence and housing, as well as the improving evidence of loan, and even monetary, growth. This week’s stock market rally appeared to be led by the financials, which was especially pleasing.”

Read about O’Neill’s book The Growth Map at AdvisorOne.

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