The Federal Reserve’s Task has certainly been made a lot more difficult by the Trump Administration. Firstly, we perhaps should restate the Federal Reserve mandate that appears to be overlooked by most analysts and commentators that look to the Federal Reserve as having the ability and responsibility to cure all.
Federal Reserve Mandate is for price stability with the maximum level of employment possible. In practice the Federal Reserve defines price stability as an inflation rate (defined as the quarterly core PCE index reading) as 2% and an unemployment rate of 4.5%. The Federal Reserve’s actual mandate is price stability and to maximise employment subject to achieving price stability. This is a nuance not often acknowledged by the markets, economists and even the entire board of Federal Reserve Governors. Determining a target rate of unemployment is ‘where the rubber hits the road’.
We currently have the Federal Reserve’s measure of inflation above the target level. This implies that price stability has not been achieved.
Phillips Curve Theory can help us to explain how the Federal Reserve estimates the maximum level of employment. In the absence of an exogenous external shock Phillip Curve Theory postulates that there is a relationship between unemployment and inflation. It relies on low unemployment being an indicator of labour supply that gives workers a strong bargaining position from which to negotiate higher wages without an increase in productivity and that this has a predictable effect on price inflation.
A simplistic way to summarise this is to assume a wages growth of 3%pa with productivity gain of 1% per annum equates to a sustainable inflation outcome of 2%pa. The RBA in Australia has repeatedly over a long period of time stated that wages growth of 3%pa was needed to achieve inflation of 2% (it was assuming long run labour productivity increases of 1%pa).
At the moment in the US, we have:
- Unemployment of 4%.
- Wages growth of 5.7%.
- Core PCE index quarterly 2.5%.
- Non-farm productivity 1.2%.
- Average hourly earnings 4.1%.
Even if we use Average Hourly Earnings and not Wages Growth, we get a sustainable inflation rate of 2.9% (4.1%-1.2%). Now Bernanke and Yellen have claimed that Phillip Curve Theory has not been applicable in the US, and this is true over the 2010-2019 period where the US was exporting its inflation to China and labour productivity was then strong enough to quell inflation, however, we are now living in a different world post the pandemic. Now we accept that judgements will be made as to the long run wages growth & labour productivity levels. Choosing how many years to estimate the ‘long run’ needs a sensible overlay because in the long run we are all dead. So, the chart below shows the US wages growth since 2021. It appears to have stabilised near the current 5.7% level. The average of labour quarterly non-farm labour productivity since 1Q2021 has been 0.97%.
We can conclude that with wages growth at above 4.1% and labour productivity of 1% the US economy is operating beyond its maximum level of employment. Extending this using Phillip Curve Theory, we would expect that US inflation will in the future be higher than it is today.
US Tariffs
All of this is important in the context of the Trump Administrations use of Tariffs. It is very difficult to analyse or comment on the policy as Trump appears to be using it as ‘the stick’ to achieve non-economic goals as well as applying it to offset unfair trade practices. Any tariff is inflationary, but a 10% across the board tariff on all imports is ludicrous. It would bring about another supply shock just like that seen in the pandemic as prices will 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 has then as a free tax grab from importers that can then be spent on other budget items such as healthcare. They are ignoring the cost which will be lower business investment levels impacted by higher interest rates.
The best analysis of the impact of Tariffs that we have seen was by the Boston Federal Reserve where there are a number of conclusions made but all show an inflationary impact. The Impact of Tariffs on Inflation – Federal Reserve Bank of Boston. We would caution that we don’t expect the Tariffs to have an immediate impact on final prices. There are natural lags in the importing of durable goods, but these may be longer than usual because US inventories are currently very high (pandemic driven caution still hanging around).
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. The US is not alone in considering tariffs on imports from China and other developing countries. Not mentioned by the fourth estate is one of the reasons Trump is proposing to levy heavier tariffs on China of 60% and 2000% on cars from Mexico is that the EU and US are now at a cost disadvantage against developing nations due to the increased cost of building the pathway to zero emissions by 2050. The EU is proposing a tariff equalisation tax rate so that imports from developing countries cannot exploit their cost advantage over EU production due to their non-compliance with EU emission standards – the CBOM. Europe has woken up to the reality that demanding everyone use an electric vehicle means that they will buying a Chinese made car because China not only makes them cheaper than the EU, but it has also taken control of the supply of many of the key inputs into batteries.
Outlook for US economy
The bond market’s reaction to the Tariff policies has been to conclude that it will mean lower US growth. This is an odd conclusion, bordering on absurd. The path to lower GDP growth is after the inflationary impact forces the Federal Reserve to raise rates and dampen aggregate demand. Aggregate Demand will be impacted by the full gamut of Trump policies and so it is impossible, at this stage, to conclude that US GDP growth is going to fall because of the Tariffs.
The recent ISM PMI data points to a strong US economy 6-9 months ahead. The ISM PMI composite, Services and Manufacturing moved above 50 in December, indicating an economic expansion 6-9 months ahead.
Interest Rates
The US bond market initially rallied last week based on an expected fall in US GDP growth forecast by what only can imagine are bookkeepers sitting inside large conglomerates making judgement on Trumps Tariff announcements. Fortunately, the reality emerged towards the end of the week when yields across the curve rose. The US 10-year still fell from 4.55% to 4.49% last week, but the two finished higher at 4.29%. If retaliatory tariffs are announced this week (mainly against the EU), then we expect yields to move higher again.
Australian yields moved in line with the US curve. The Australian 10-year discount to the US 10-year has narrowed to 10bps (from 15bps) in expectation of most of the ALP spending announcements over the past month successfully being implemented post the Federal election. We expect that Australian bond yields will move back to at least the 75bps premium to the US rates should an ALP-Green-Teal alliance form the next Federal government. This is the premium last seen in June 2022 after the last Federal election.
Major Credit Markets
US investment grade (IG) markets were slightly weaker after a mixed U.S. payrolls report, weak consumer sentiment data and revived worries over trade war. However, Fed members commentary regarding the steady rates doesn’t help the corporates who need lower rates to boost profitability.
In Australia credit margins remain very tight, rebounding from recent weakness. The Qld Treasury last week issued $2bn of a new 4.25-year floating rate bond last week in a book that was bid $3bn. The book size probably reflects the floating rate nature of the bond rather than the Qld path to non-investment grade status that, unlike Victoria, is not inevitable. The bond priced at 40bps above the 90-day BBSW rate. By comparison Ausnet issued a Tier 2 30-year non call 6-year at 225bps over swap. Elsewhere Westpac issued a vanilla 10NC 5-year Tier 2 at the very tight 152bps, and ANZ sold a 5-year senior at 82bps.
High Yield Markets
US high yield markets remain well bid, seemingly ignoring the disruption of potential tariffs. HY issuance remains strong with lenders via markets still supportive. Despite slightly weaker IG credit, HY spreads narrowed over the week. Sub sectors seeing large drops in spreads in January have been Automotive, Retail and Energy.
Hybrid margins were lack-lustre last week on average volumes with no overall trend. Longer dated hybrids showed higher volumes with the exception of the September 2025 maturity WBCPH.
Re AN3PH and reinvestment. APRA have stated that hybrids up to Dec end 2026 can be rolled. ANZ has the option to exchange (which includes redemption) ANZ Capital Notes 5 on the first optional Exchange Date, which is 20 March 2025. ANZ must provide holders with an Exchange Notice at least 15 business days before the Optional Exchange Date. ANZ would need to issue the Exchange Notice by Wednesday, 26 February 2025 and with it any reinvestment offer.
Listed Hybrid Market
Hybrid margin curve
Hybrid margins have been quite steady in past weeks on average volumes. This gives opportunity to adjust holdings. The scatter diagram below shows the major banks and Macquarie Group and bank hybrids. The slope of each group rises mildly over time with some flatness in the major banks after 2030. There is value in the major banks above the line: NABPH Dec 2027 maturity, and after 2030, AN3PK, CBAPM and AN3PL. Short term WBCPH at a 2% margin is a good place to avoid volatility. Below the line for the major banks, NABPF and CBAPJ look expensive. For Macquarie, MQGPD gives good near-term yield as opposed to MBLPC some 0.30% tighter. MQGPE and MBLPD are at major bank levels and should be switched in a near maturity major. Longer dated MQGPF and MQGPG maintain an appropriate premium to the major banks.
Forward Interest Indicators
Australian rates
Swap-rates fall move in line with bond rates.
Swap rates:
- 10-year swap 4.37%
- 7-year swap 4.20%
- 5-year swap 4.05%
- 1-month BBSW 4.22%
