A few weeks ago, after the attempted Trump assassination, we began collecting our thoughts on the implications of a Trump Presidential win and/or the Republicans gaining control of the Senate (they already have Congress). Although there are few details yet, he has promised “lower taxes, bigger pay checks, and more jobs for American workers” by enacting universal baseline tariffs that “reward domestic production” and tax foreign companies. During his presidency, federal debt held by the public rose from $14.4 trillion to $21.6 trillion, influenced by Trump’s tax cuts, particularly his reduction to the corporate tax rate. In the absence of the pandemic and given more time these tax cuts may well have had a similar impact to the Reagan era tax cuts.
We will all be reading, in the months ahead, a lot about the Reagan era and how it compares to what may become known as the Trump era.
Reagan Era Policies
The economic policies promoted by Reagan were centred on the supply side of the economy. They included:
- Slowing the growth of government spending with an aim of balancing the Federal Budget.
- Reducing federal income and capital gains tax.
- Reducing government regulation.
When reviewing the Reagan era, it is important to first acknowledge that his term commenced in 1980 after the oil shock that ignited inflation, so has been incorrectly connected with the Federal Reserve increasing interest rates at that time. Equally we don’t include the increase in US defence expenditure that contributed to the successful end of the Cold War with Russia when reviewing Reagan policies. It was a different time with geopolitical risks that we have not seen since.
The central policy of the Reagan era was then contained in the Economic Recovery Tax Act 1981 that reduced both income and capital gains taxes that together with reduced government regulations have been widely attributed to the entrepreneurial revolution that even today can be seen in the way US corporations have a key role in the way the entire global economy operates. In the 1970s the US experienced persistently high unemployment and high inflation (stagflation). This decade-long period of stagflation discredited the Keynesian-based theory called the Phillips Curve Theory (the truth here is that governments had been misusing Keynesian economic orthodoxy for their political purposes). Paul Volker as Federal Reserve Governor is widely accredited with bringing down inflation with three years of monetary base contraction (based on Milton Freidman Monetary Theory). However, it was the increase in labour productivity that resulted from the entrepreneurial revolution that also deserves much of the credit.
It is worth pointing out here that the Republicans passed the tax reductions in 1981 when they had control of the Congress, but they did not control the Senate during the Reagan years so there was some bipartisanship on the policy platform. In fact, the Reagan era policy themes remained central to US economic policy through the Bush and Clinton administrations. The idea that a good government should aim to balance the budget and be an efficient regulator were only abandoned during the Obama era when Modern Monetary Theory was used to fund and justify an increased government role in the economy and the global warming thesis was used to create a “crisis condition” like a war period where many inefficient levels of government regulation were justified.
The rise of Harris-Walz in the polls, however, forces us to now shift our focus onto the implications of the Democrats retaining the White House but not having control of either the Senate or Congress (a “just not Trump” democratic outcome). Without the ability to pass laws through the Congress and the Senate the Harris-Walz domestic policy agenda is largely irrelevant. Everything from tax policy and welfare spending to the environmental policies will not pass through at least one of the houses of government. Taxes will rise with the expiry of the Trump income tax cuts but the planned targeted taxes on the more affluent and the “unrealised capital gains” form of taxation are unlikely to be enacted.
This “no change” outcome, frankly, makes our job a lot easier, but it will leave the US with structurally embedded inflation (supported by wage and welfare income levels). This is something we have seen in Australia at a federal level since the Rudd/Gillard/Rudd period where the Senate no longer acts as just a house of review because it is filled with rabid activists seeking instability. It has been next to impossible for any party that has formed government in the lower house to achieve real economic reform. Maybe this will be the same outcome in the US.
A Harris-Walz White House will unequivocally have control of US foreign policy. While it likes and needs funding support from Congress it is always the President that sends US troops into battle. This is an area of weakness for Harris (and why she chose Walz as a military veteran). We need to watch for an increase in rhetoric by Harris-Walz on the necessity for US involvement in a regional conflict. This is unlikely to be in the Middle East unless Iran has miraculously been hiding its actual military strength under what must have been a very large rock, or in the South China Sea given the weakness in the Chinese economy that has made it more dependent on export income. The most likely avenue is in the Ukraine-Russia conflict. Given that Trump has boasted he would be able to end this conflict on his first day in the Oval Office (not necessarily with a good outcome for Ukraine), it is understandable that the Democratic Party will seek to confront Russia more directly for the political payoff at the ballot box. This has global implications but at a regional level they are negative for the EU that already has an economy spluttering under the burden of massive government debt and over-regulation.
Now that equity markets have fully recovered from the recent Yen carry trade dummy spit the risks lie with increased geopolitical risk in the months ahead. A misspoken word from Harris on the campaign trail could easily see another bout of risk off selling to much the same degree we all witnessed in August. Even without this there is a risk that a 50 basis point cut in rates by the Federal Reserve in September sees the Yen rally and another bout of risk off selling emerge linked to the Yen carry trade. We all need to be watching the value of the Yen closely.
Interest Rates
The short end of the US yield curve was nearly unchanged last week with traders focused on whether the September rate cut will be 25bps or 50bps. Two-year yields rose only 1bp. The long end moved 10bps higher with 10-year yields finishing at 3.91%. The market ignored the 9.9% surge in durable goods orders, a key leading indicator. It could also draw little solace from the monthly core PCE price index that remained steady at 2.6%. This is the inflation reading the Fed uses.
Australian bond yields rose last week initially on the back of a stronger than expected CPI July reading that showed inflation remains sticky and then the surprising strength of retail sales that were able to rise even after the EOFY sales surge. The 2-year finished 13bps higher at 3.65% in NY and the 10 year was up 10bps at 3.98%.
Major Credit Markets
Like the equity markets the credit markets were thankful for the stronger economic data and credit spreads tightened into nearly a two year low point. The post reporting season rise in corporate bond issuance in the week ahead may see spreads widen out somewhat.
In Australia credit margins also tightened considerably with the markets once again assuming that there is some sort of causal relationship between the US and Australian economies that is baffling. While the Australian economy remains robust and inflation is still a problem, investors appear to be showing a preference for floating rate bonds. Issuance was lighter last week with only one major investment grade transaction, Mizuho Sydney Branch issuing $750m of a three-year senior bond at a margin of 0.75%. Looking forward several corporates are doing roadshows for potential bond deals, including Scentre Group, NSW Ports, Qantas and ANZ.
High Yield Markets
High yield markets again remained strong given the firm equity markets and the expectation of a Fed rate cut in September. Recovery from the recent margin rise is almost now complete.
Hybrids were essentially flat for the week as the market continues to sell to fund the new Macquarie group hybrid. Volumes were 20% above average with most volume in longer-dated hybrids such as CBAPM and PL, AN3PK and NABPK. The shorter-dated WBCPH also traded at above average volume.
The Australian Unity MCI (AYUPA) continues to recover from the recent entitlements issue, with trades last week at $81.00. This level gives a yield of 8.82%. Interest may be driven by the large upcoming semi-annual dividend in early October.
Listed Hybrid Market
Hybrids – Macquarie issuance still felt
As mentioned above, hybrid margins have not recovered from selling to fund the recent Macquarie group hybrid. The chart below shows the difference in margin from the date of the announcement that Macquarie was looking to issue (2 August) to now. Nearly all hybrids have widened in margins, major and non-major banks alike. All major banks have been sold off especially Westpac hybrids. It would be expected that Macquarie hybrids would be sold – as shown MQGPE and MQGPF have borne the brunt of the Macquarie hybrid selling. The other non-majors have had their fair share of selling as well. Settlement for the new Macquarie issue is Friday, 13 September which still gives a few weeks of selling time.
It is worth looking at how Macquarie hybrids trade versus the major banks. The chart below shows the average margin history for the major banks and the Macquarie Bank and Group hybrids together (given the market doesn’t really show a margin preference). As shown the Macquarie hybrids closely follow the major banks and in the past 12 months close to the major bank margin, although the chart data does not account for some mismatch in time to maturity, the current crop of Macquarie hybrids having a slightly shorter tenor.
Looking more closely at margin changes over the week, the second chart shows the major banks’ margin curves from the trading day before the Macquarie issue was announced to Friday, 23 August. Most of the curve was affected, more so at the long end. There was also some widening of Macquarie hybrid margins, mainly the three longer-dated Macquarie Group issues. The two Macquarie Bank hybrids were steady.
Forward Interest Indicators
Australian rates
Swap rates steady with market rates.
Swap rates:
- 10-year swap 4.11%
- 7-year swap 3.94%
- 5-year swap 3.82%
- 1-month BBSW 4.31%
