Last week the US electorate decided between the Republican America first policies as represented by Trump during the campaign and continuation of Bidenomics under Harris. It is worth noting that Bidenomics was still the Obama economic approach which was based on rewiring the US economy so that it had a much larger government sector and a reliance on modern monetary theory to fund it (this money printing approach to funding fiscal expenditure was possible because at the time the US was exporting its inflation and its industry to China). This would have meant under Harris a 7bp increase in corporate tax, increased regulations on business, a smaller private sector and no plan to address the US government debt problem.
It is now highly likely that the Republicans will control all three houses of Government (President, Congress and Senate). This would make it much easier for Trump to enshrine the corporate tax cuts that were due to expire and impose his promised 10% minimum tariffs on imports. There are implications here at a few levels.
The fiscal deficit in the short to medium term will increase and this will need to be funded with increased Treasury issuance. It is possible that, with Yellen no longer Treasury Secretary, that we will see under the new administration, a balanced term profile on US debt issuance. 12 months ago, Yellen switched from issuing 10-year bonds to short-dated Treasury Bills in an effort to manipulate the US yield curve when the US 10 year was threatening to break above 5%. At the time the Federal Reserve conveniently switched to a dovish tone with the release of dot point chart that forecast 3 rate cuts in 2024 (that the market extrapolated out as 6 rate cuts of 25bp. The Federal Reserve has now cut rates since August by 75bps and so has met its 2023 dot point projection).
The US benchmark yield curve shape has now changed from an inversion one year ago to a normal curve.
This may reflect a range of factors that include:
- The US employment monthly average remaining at or above the 125,000 per month 12-month average that would translate into a steady rate of unemployment near the current level of 4.1%. There has been a lot of volatility in the nonfarm payrolls data since June when the hurricane season and more recently the Boeing worker strikes made this economic indicator unreliable. Even still it is hard to see how the Federal Reserve could be honestly concluding that the US employment market is weakening. Yes, it has weakened since the post pandemic surge but despite an increase in population from immigration, jobs growth has been sufficient to keep the unemployment rate beyond the measure of Full Employment (4.75%).
- The ISM PMI Services index surge last month is suggesting an increase in labour demand for service activity in 6-9 months’ time. The reading of 56 last month was unexpectedly strong. ISM services is important at a time when unemployment remains very low because services activity has a higher labour component than manufacturing activity.
In context this rise in the ISM PMI Services Index and with it the ISM PMI Composite index is very important. In mid-2022 the markets were certain that the US economy will enter a period of economic contraction in the March quarter of 2023. This was due to the combination of two key indicators:
- An inverse benchmark yield curve.
- An ISM PMI Composite index reading below 50.
Historically this combination had a 100% accuracy rate on predicting a recession 6-9 months ahead. This was a false indicator at the time because of the pandemic distorting the signal.
We can logically now predict – on the same basis – that with a normal US yield curve and an ISM PMI reading above 50 (and increasing) that US economic growth will be stronger 6-9 months ahead. This will be further supported by the stimulatory measures we expect the Republicans to enact quickly with control of all three houses of government, but if anyone had any further doubts surely these have been silenced by the surge last week in the US equity markets.
The small caps as represented by the Russell 2000 are likely to be the biggest beneficiaries of the lower tax rate and lower regulatory requirements promised by Trump.
A major part of the Trump plan that may be enacted very quickly is a 10% tariff on all imports. Subsequently we may then see specific tariffs on Chinese exports to the US. The early appointment of a pro-tariff ex lawyer to the US steel industry is a clear signal from Trump that he intends to increase tariffs as his first priority. Donald Trump asks arch protectionist Robert Lighthizer to run US trade policy
The US may get away with specific tariffs on specific goods but only for short periods and only where the US can find then make the same product itself as cheap as China or source it from a favoured trade partner. If the Trump administration includes people like Musk and Paulson and they have not been able to dissuade Trump from Tariffs, then this reveals more about Musk and Paulson than perhaps the markets are prepared to accept.
Any tariff is inflationary but a 10% across the board tariff on all imports is ludicrous. There will be another supply shock just like that seen in the pandemic as prices surge 10% on most durable goods. There is nothing ‘transitory’ about this, so the Federal Reserve will choose to either let inflation increase or raise rates. When it raises rates, the USD will rise. If the USD rises by 10% then the impact of the 10% tariff is negated as imports in USD are now 10% cheaper in USD terms. The Trump economics team see this then as a free tax grab from importers that can then be spent on other budget items such as healthcare.
The problem is then that other countries respond with tariffs on US production and a trade war ensues. We will be watching the trade balances of China, US and EU as this tariff process unfolds.
Technically the USD looks like it is tracing out a flag (symmetrical triangle) pattern where there is a 75% probability of an upward break out. This would be consistent with the Federal Reserve being forced to stop cutting rates at the December meeting and perhaps even being forced to increase rates in 2025.
Interest Rates
The US bond market weakened before and after the US election with yields rising across the curve. The market is pricing now for higher inflation for longer. The decision by the Fed Reserve to cut rates by 25bps and for that matter the BOE to cut also by 25bps both look entirely political (more in Macro Commentary below). The 25 bp cut by the Fed had very little impact on the Fed Funds rate future expectations. The US yield curve is now positive in stark contrast to the shape3-6 months ago.
Australian bond yields moved broadly in line with the US. It was a slow news week in Australia with much of the finance industry focused on the Melbourne Cup Carnival. The 2-year yield rose 6bps from 4.08% to 4.14% and the 10-year rose 10bps to finish the week at 4.65%. As it appears we have entered the Federal Election period now with spending promises being made, we may well see the yield curve steepen further over the months ahead.
Major Credit Markets
US investment grade (IG) markets rallied post the election result as corporate America looked to Trump’s stimulative policies. Additionally, the Fed rate cut is supportive of credit. Average IG spreads narrowed about 4 bps over the week. BBB spreads fell by a large 12 bps to 1.22%. Money flow into IG funds was very strong.
Australian credit markets were also strong. Three of the major banks reported last week but only NAB followed with a Senior bond issue. NAB issued $1.8bn at 3MBBSW +82bps and it is trading in the secondary 5bps tighter. Westpac is expected to bring a new senior offer next week. There is also an expectation that all the banks will bring new Tier 2 issues this month given current tight trading margins and the need to test the depth of the market for it to replace AT1. AMP Bank came with an odd 1-year senior bond at 3MBBSW + 75bps. Given the short term it will not be repo eligible. Of note was the Fitch downgrade of Suncorp Group from A+ to A- post the sale of Suncorp-Metway Bank to ANZ.
High Yield Markets
US high yield (HY) rallied dramatically on the rate cut and the election result which fuelled the equity market, always good for HY. As the chart shows, HY is now at multi-year lows, in fact at post-GFC lows!
As we have seen many times before, the Australian hybrid market movements are at odds with other credit markets. Last week the average major bank hybrid margin moved wider by 0.14% to 1.94%, briefly hitting 2.00% mid-week. Some of this may have been liquidity related, with volumes light around the Melbourne Cup Day. Nevertheless, selling was evident in most major bank hybrids, especially short-term issues like AN3PH and CBAPG. Further, mid curve issues like WBCPK, CBAPK and NABPK had been over bought previously each trading under a 1.80% margin, the selling bringing them back in line with the curve, closer to 2% margins.
Listed Hybrid Market
Hybrids – yield premium to ordinary back shares disappears.
Typically, the yield on hybrids should trade at a discount to a banks ordinary share dividend yield given hybrids better position in the capital structure. However, the recent rally in hybrid margins (despite some widening last week) has depressed total hybrid yields. Similarly, the rise in bank share prices has depressed bank dividend yields. The chart below, courtesy of Evans and Partners, shows the yields grossed of each. The rally in bank share prices may have had a larger effect, bank yields well down on 2023 levels.
An easy method to show the difference is the simple mathematical gap between the two as shown in chart 2. The gap is now at zero. The question is how this is appropriate? Eventually financial reality will return the and the gap will widen. This may be as a result of bank yields returning to previous levels. Meanwhile yields are distorted by APRAs actions on hybrid and the strong demand for equities.
Forward Interest Indicators
Australian rates
Swap rates rise with bond rates, long rate moves above bill rates.
Swap rates:
- 10-year swap 4.537%
- 7-year swap 4.39%
- 5-year swap 4.27%
- 1-month BBSW 4.31%
