That’s the way markets are feeling at present. Following the tax cuts, analysts and bond traders have had some time to digest the information and are now just starting to react.
The problem is that most analysts can come up with about 3% growth for 2018 and that means a deficit prior to the increase in the debt ceiling if about $1.2tr. Post the debt ceiling, that deficit balloons to about $1.5tr. But here’s the catch. The catch is many analysts predict growth in 2019 at around 2.5% or lower.
The Treasury needs growth in excess of 3% to balance the budget and with time to reduce the debt. The problem is that as growth slumps, borrowing costs are increasing as revenues are falling. Credit expansion may be the go and let inflation do the heavy lifting. Bond investors hate that and so should the ratings agencies.
The U.S. economy is in a difficult position now, with a mature economy, low productivity and with a workforce that is at full employment. To further wage increases, productivity has to lift and so too the growth rate. It’s a no brainer. I just don’t understand why so many economists knowing this still say everything is fine.
Bond investors hate large deficits and, even more so, increasing inflation. Combine that with no more central bank money and increased issuance, and the tantrums that we are seeing in the bond market are only just the start. The 30-year treasury auction today saw soft demand with the bonds barely trading through the issue level. The 30-year traded at 3.14%.
In 2017, the bond issuance in the U.S. was about $550 bio with the Fed buying about $50bio a month. Today, the Fed is slowing its purchases and not reinvesting coupons. The issuance is now expected to be about $1.5 tr – that’s about a tripling of issuance. Yields have a way to go and even further if the deficit is not constrained. The blowout under Trump is now expected to be in the order of $500 bio. The deficit under Trump according to B of A’s chief economist is on track to exceed 5% of gross domestic product by 2019, and the largest for the economy while at full employment since WWII. If Joseph Song is correct then the U.S. is in for a period of significant tightening of rates by the Fed and higher interest rates.
The increase in bond yields is now only just starting and those increases will affect valuations of equities which are stretched on optimism and a one-off cut in taxes. The hawks are starting to hatch and that could be a problem. Bond yields could rise dramatically if and when it becomes apparent that 3% growth won’t be achieved or maintained. It’s a circular argument but one that leads to significantly higher rates. Nerves will be frayed, and investments held back as traders’ search for more reward on the risk. If Trump does not get his touted 5% growth rates, then the 30-year could easily back up to 5% if the deficit keeps ballooning and growth is stuck around current levels. William Dudley has suggested that he would support 3 rate hikes this year if the economy continues to grow. That’s a big drag on growth should those tightenings occur.
And if this was just the problem it would be easy. However, world growth is stirring elsewhere, leading to increases in yields elsewhere. The UK economy seems to be shrugging off Brexit for the moment and yields are rising there. The UK may well see rate hikes in the near future.
For equities, the scenario is now just a little more complicated. The work needs to be done to determine just who the winners are, it is now not simply a matter of dialing the numbers into a computer and letting a machine decide what to do as volatility is climbing. That’s something many of the experts forgot, what happens when volatility is no longer a one-way trade. The Vix closed around 32 today.
Equities swooned on the day. Tumbling after a reasonable opening as investors remain on edge. Equity investors are now just starting to be concerned about what bond investors are thinking about. Financials and consumer discretionary were the hardest hit.
Equities: The S&P 500 fell 3.75%. The Dow collapsed 4.15%. The Stoxx 600 fell 1.6%.
Currencies: The pound rose 0.3% while the Bloomberg Dollar Spot Index fell 0.1%.
Bonds: The ten-year hit 2.86% again before falling to 2.83%. The 2-year closed at 2.12%.the ten-year bund closed at 0.707% and the UK gilt closed at 1.617% and the OAT closed at 0.99%. The U.S. curve closed 2/10 at 71.5bp, 2/30 at 101.4 bp and the 10/30, closed at 29.7 bp. The U.S. 5-year closed at 2.55.
Commodities: Gold fell 0.1% and WTI fell 1.2 %. Copper fell 0.4%.
Bitcoin is trading around $8,255 and steady.
Aussie Market Today.
Equities will sell after a reasonable day yesterday. The weight of selling will be too great for equities to hold up.
Bonds will stage a rally coming into the end of the week and also in response to the U.S. market. The AUD 10-year versus the U.S. 10-year is now about 3 bp. Aussie bonds can rally through this spread however the currency may feel the pressure. AUD to be pressured on the day.