From being inverted in recent years, with the yields on short-term bonds higher than those with longer maturities (which generally foreshadows an economic slowdown), the US yield curve has steepened thanks to the big sell-off of the longest-dated bonds.
When the markets made big bets on the re-election of Donald Trump before the November election, sharemarket investors were extremely bullish but bond investors were cautious about the implications for inflation of Trump’s economic platform.
It would appear that bond investors are even more anxious about that agenda today than last year, demanding compensation for the increased risk, and equity investors are starting to share that anxiety.
Equity investors were bullish in the lead-up to the US election due to Trump’s promised tax cuts and deregulation, but now inflation is becoming a bigger concern.Credit: Bloomberg
The combination of big tax cuts and deregulation ought to spur increased growth, which is why equity investors were excited. When Trump’s cherished tariffs and his plans for mass deportation of illegal immigrants are factored in, however, it generates fears of a new and significant outbreak of inflation.
The movement in the longer-term yields can, therefore, be seen as the pricing in of the risks of the Trump agenda; risks that because of his promised tariffs on everyone (and particularly punitive tariffs on China) have a global dimension.
IMF managing director Kristalina Georgieva.Credit: Bloomberg
Minutes from the Fed’s December meeting of its Open Market Committee, which makes monetary policy decisions, show the Fed has begun factoring in the potential impacts of Trump’s trade, immigration, fiscal and regulatory policies, albeit that they referred to the “elevated uncertainty” of their specifics, scope and timing.
“Participants indicated that the committee was at or near the point at which it would be appropriate to slow the pace of policy easing,” the minutes said.
Both the Fed’s own projections and the market’s pricing reflected an expectation in December of at least two more rate cuts this year. Now the market is pricing in only one, at best, and some US economic analysts are talking about possible rate hikes.
The International Monetary Fund’s managing director Kristalina Georgieva said on Friday that Trump’s policies were already driving up longer-term borrowing costs globally and adding to global economic uncertainty.
“That uncertainty is actually expressed globally through higher long-term interest rates,” she said.
She said the impact of US trade policies would be most acute on countries and regions integrated with global supply chains and that the US dollar’s strength could fuel higher funding costs for emerging market economies, especially low-income countries.
The dollar has been on a tear since September, surging more than 9 per cent against the trade-weighted basket of its major trading partners’ currencies (and more than 12 per cent against the Australian dollar).
That might be partly a function of the sharp rise in yields on its longer-term government bonds, but it would also incorporate some of the anticipated effects of Trump’s tariffs. When one country imposes tariffs on another, the imposing country’s currency tends to strengthen and the currency of the country subjected to the tariffs tends to weaken.
If Trump actually does what he has said he will do (there’s some doubt over whether the threat of tariffs is a negotiating ploy), the dollar ought to strengthen further. The combination of higher US interest rates and an even stronger US dollar would be very disruptive to the global economy and potentially destructive for some debt-laden emerging economies.
It would also not be good for sharemarkets.
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Since the Fed’s 25 basis point rate cut in December, the US market has fallen 4 per cent. That’s probably due to the combination of the winding back of expectations for more rate cuts this year, the rise in longer-term bond yields and the realisation that Trump’s policies, if implemented, might result in stronger growth – but they could reignite inflation and force rates even higher.
Investors who had been giddy at the prospect of Trump’s tax cuts and deregulation and who pushed a market whose valuations were already stretched to record levels last year have sobered as they have worked through the implications of getting what they wished for.
An over-heated and highly disrupted economy, a massive increase in US government deficits and debt (with a consequent massive increase in the supply of bonds and another source of pressure for higher interest rates if the market is to absorb them) and a fresh burst of inflation that forces the Fed to respond are not a recipe for a continuation of last year’s bull market.
Nor would it be conducive to global economic growth and geopolitical stability.
As bond markets are signalling, this year the world is moving into an increasingly risk-laden environment as the uncertainties around Trump’s “America First” agenda that are now driving the markets are dispelled by the real economic effects of its implementation.
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