Last week we wrote about a near-term bullish potential scenario for the US economy. This scenario is based on a confluence of long-term and short-term trends. As we wrote:
- From a longer-term perspective, we note that the health of the US consumer has improved significantly over recent years. And this is important for consumption – by far the largest component, to the tune of around 70 percent, of US aggregate demand.
- From a shorter-term perspective, the weakening US dollar over the last nine months is an effective form of monetary stimulus. Combine this with a renewed prospect of genuine corporate and personal income tax cuts, and we have the potential for a very real boost to US economic growth. This would likely be positive for US equities, and the US dollar.
Now, should we end up in this scenario, we would expect US bond yields to rise on the prospect of higher future growth. We would also expect short-term rates to rise more quickly over time as well.
And if you believe Federal Reserve (Fed) Chair, Janet Yellen, the “slack” in the US economy – which is a measure of labor underutilization – has now run out. This is illustrated on the chart below by the purple negative boxes which, in 2017, has become a positive box for the first time since the Global Financial Crisis.
If Yellen is correct and there is no more “slack” left in the US economy, then a new dose of fiscal stimulus (from Trump’s proposed tax cuts) would cause the US economy to operate above its capacity, causing inflation to accelerate. The response from the Fed would be to hike its short-term policy rate.
Some market participants believe that inflation could accelerate uncontrollably and the Fed would be forced to make extreme rate hikes (as were seen in the 1970s when rates hit the mid-teens percent). We do not believe this can or will happen.
One simple reason why we hold this view relates to the difference in the level of government borrowings between the 1970s and today. Back then, federal debt-to-GDP was around 30 percent. Today, it is a little over 100 percent, as shown below.
And it’s not just the level of debt that is important in our analysis: it is the structure of this debt. As illustrated by the chart below, prepared by Deutsche Bank, the majority of federal debt outstanding has a maturity of five years or less. This means that, should short-term interest rates increase, then over a five year period, most of the US government’s debt will have rolled over to higher interest rates.
And the maths on the effect of such higher interest payments by the US government is pretty simple: with debt-to-GDP around 100 percent, this means that every one percent increase in interest rates will result in around negative one percent contribution to GDP growth.
Taking one full percentage point of economic growth out of the US economy is significant. This is, in effect, negative government stimulus. And this negative stimulus would likely take some of the heat out of the US economy, thereby negating the need for significant further rate increases.
So this is our view. We believe US rates will not fly up because, at least in part, the negative government stimulus that would result from higher borrowing costs would very quickly drain the heat out of the economy. We’d love to know if you have a different view.
Andrew Macken is Chief Investment Officer with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.