Fixed income investors are grappling with conflicting signals emanating from the broader macroeconomic environment, and these have the potential to induce more volatility in the bond market. While the US economy is still resilient, real rates are elevated and if they remain higher for a longer period that could potentially cool demand.
Barely a few weeks ago, the US Federal Reserve (Fed) started its easing cycle with a hefty 50 basis points rate cut. But markets have already toned down their expectations for further reductions given the strength of the US economy.
The Fed’s move was prompted by rising unemployment and slowing inflation. What was notable about the Fed’s first reduction in 4-1/2 years was the size of the cut (50bps as opposed to 25bps), at a time when US equities are at all-time-highs and US credit spreads are at record tights.
Data prints since the Fed’s September meeting have been stronger than expected. For example, Non-Farm Payrolls data showed the labour market remains solid despite an uptick in the unemployment rate. Since the pandemic, markets have tended to extrapolate from the most recent data, so it’s important to keep in mind the larger structural themes impacting the economic cycle.
Elevated fiscal spending and comfortable household and corporate balance sheets, underpinned by surging risk markets are buttressing the US economy against the pressure exerted by high policy rates that have prevailed for more than two years. In a world of less labour and commodity supply, this means inflation is far easier to generate now, a key reversal from the 2010s.
This is shown clearly by US household surveys which indicate households now see far higher and more volatile inflation. It is this combination of supply scarcity in key resources and stronger demand that makes the current regime different to the one before.
Why Current US Fiscal Spending is a problem
The chart above demonstrates the unusual nature of current government spending. Before the pandemic, when the economy was strong and the unemployment rate remained low, government spending fell. This was the appropriate fiscal response because in such a scenario governments spend less on unemployment benefits even as they collect more in tax revenues.
Since the pandemic, the opposite has happened, with the government spending more as the economy improved. When an economy is performing well, the last thing it needs is even more demand, and with it more inflation. This elevated pace of government spending goes a long way in explaining why the US economy has avoided recession, despite the most aggressive hiking cycle in a generation.
More spending ahead
We believe the deficit scenario is unlikely to change under the new US administration, with the country’s national debt expected to rise further from $36 trillion, which is about 120% of its GDP. The IMF, in its latest Fiscal Monitor report, projects the US fiscal deficit will be more than three times that of Germany.
While US inflation has softened from its 2022 peak, which was the highest level in more than four decades, it’s still not below the Fed’s 2% target. Geopolitical uncertainty, particularly the ongoing conflict in the Middle East, has the potential to rattle oil markets. The outcome of the US election could also raise tensions on trade and immigration, potentially spurring inflation.
One key factor that will help fight inflationary pressures is elevated interest rates. In its latest summary of economic projections, the Fed estimates the neutral rate, i.e. the level that neither stimulates nor restricts the economy, is 2.9%. US interest rates currently stand at 5%, well above that level, and near their highest since the Global Financial Crisis.
Bond yields across the curve declined over the summer, encouraged by increased talk of a hard landing or recession. However, yields have started to slowly climb again given the more volatile economic narrative. Yet, the future path of the Fed’s easing cycle is unclear, with investors debating the pace and depth of the easing cycle. In our view, the first 100 basis points cut will be the easier part for the Fed, with the outlook for 2025 uncertain.
The value of active minds: independent thinking
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