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  • Investors are underestimating the US economy’s potential to grow faster and generate even more inflation than expected, says Sonal Desai, the director of research for Templeton Global Macro.
  • Higher inflation would extend the sell-off in Treasurys that has taken the 10-year yield above 3%, she said. 

While speaking at a conference in Frankfurt late in 2017, Sonal Desai forecast that the 10-year Treasury yield would easily top 3% sometime this year.

Desai, the director of research for Templeton Global Macro, recalls that the audience laughed.

“I feel somewhat vindicated by what happened a few weeks ago,” Desai said at a media briefing hosted Wednesday by Franklin Templeton Investments, which manages $$732.5 billion in assets. 

The benchmark yield topped 3% late in April as investors considered that US interest rates and inflation were on the rise. And even now, Desai thinks investors may still be making jest of the level of inflation brewing in the US economy. While fair value on Treasurys could theoretically take the 10-year yield to 5% or 6%, the abundance of demand and liquidity would keep it more contained. It could rise “maybe above 4%,” but certainly higher than where its current level just shy of 3%.

“While it is not going to be out of  hand, it is going to be outside of the expectations of most investors,” Desai said. “No attention is being paid to it, and more attention should be.”

Of course, the 10-year’s climb to 3% and the stock market’s correction in February prove that higher inflation is on Wall Street’s radar. 

Yet, according to Desai, investors are downplaying the economy’s potential to create the demand that drives inflation higher, even after this expansion entered a 107th month in May to become the second-longest ever. According to Desai, the economy’s underappreciated potential is partly explained by its sluggish pace during this extended recovery, and the fact that it has grown at a rate of around 2%-2.5% — “disappointingly” above potential.

Gross domestic product growth closer to 3%, such as we saw late last year, should become more common as fiscal stimulus accelerates the economy over the next three years into the cycle’s end, Desai said. 

“I’m not making a call on whether this is a sustainably higher level of growth,” she said. “But I do think over the next couple of years, people are significantly underestimating the ability of the US economy to surprise on the upside not just on GDP, but also on factors like inflation.”

Higher inflation would come from “usual suspects” like wage growth and companies raising prices, Desai said. The mysterious breakdown of the relationship between a low unemployment rate and higher wages — represented by the Phillips curve — is one reason why she’s left with little comfort that wages won’t rise again. 

Desai doesn’t shy away from the possibility that higher inflation could hurt some portfolios. Treasurys would further sell off, sending yields higher, while stocks could become more volatile. But the extent of the market disruption would depend on how inflation rises, she added.  

This episode of inflation could be more challenging for investors who, disarmed by years of easy monetary policy, have come to expect the Federal Reserve to intervene in rocky markets. 

But an even younger subset of investors could feel even more ambushed by the impact of rising inflation. 

“There is an entire generation of traders that has never actually traded in a world where inflation is going up, or US Treasurys are actually rising, or the central bank is consistently raising rates,” she said. “If you were a junior trader who came in the day before Lehman went down and actually kept your job, you have a very different view of the world than anybody who has lived through the world pre-Great Financial Crisis.

SEE ALSO: Morgan Stanley says there’s one piece of the market you need to own as stocks run out of steam

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