US election, US budget deficit , inflation, bond yields, the USD, the Fed, equities, gold and crypto...beware the knee jerk?
Bond yields spiked higher on the prospect of a Trump victory in the US Presidential election and the USD surged.
Despite higher bond yields, equity markets rallied on the expectation of corporate tax relief under a Trump Administration and/or the absence of any increased corporate taxes that may have been instituted under a Harris Administration.
A little surprisingly in my view, gold prices declined sharply while its latter-day relative – crypto – surged. Of course, gold is generally challenged by rising bond yields (as are equities) and by an appreciating USD, so the knee-jerk reaction is understandable. Crypto surged on the prospect of lighter regulatory oversight.
I had thought (and still do) that certain idiosyncrasies attached to the current environment mean that it would take substantially higher yields from here to curtail gold’s appreciation, and I remain sceptical of the durability of the USD rally over the medium term despite higher bond yields.
The rise in bond yields reflects two factors:
It now seems certain that bond investors will be asked to swallow an equally gargantuan amount of bond issuance needed to fund a budget deficit of such magnitude. In so doing the bond market will likely develop episodic and potentially severe bouts of indigestion.
That would send bond yields even higher.
This is occurring at a time when inflation, at least in the US is proving to be “sticky”.
That US inflation “stickiness” is likely to be exacerbated by the policy agenda of President Trump 2.0.
Certainly, Trump 2.0 has undertaken to embark on a high-grade weaponisation of trade that will fuel inflation via aggressive tariffs. That will inevitably result in higher in inflation (and bond yields).
Moreover, Trump’s plan to exert more influence over the Fed's decision-making process is not something bond investors are likely to look kindly upon. To emasculate the Fed’s independence by making the policy rate a more “political” device will inevitably result in higher inflation, expectations thereof, and higher medium and long-term bond yields.
In this context, US 10-year bond yields might, at best, remain stuck at around current levels.
Worries about the deficit and future higher bond yields will undermine the attractiveness of US bonds as a “safe haven” investment. Such fears had driven the gold price to record highs (before last night’s reversal), even as bond yields rose. I think that dynamic remains in play over the medium term and anticipate a resumption of gold’s appreciation.
Crypto assets will continue to do well.
More broadly, the large US deficit and attendant bond supply may chip away at the “exorbitant privilege” the USD has enjoyed as the world’s reserve currency, particularly if it occurs against a background of a less independent (more “political") Federal Reserve.
The diminution (perhaps permanent) in the attraction of US bonds as a “safe haven” and an emasculation of the Fed’s independence is why I’m yet to be convinced that higher US bond yields will see further appreciation of the USD.
Importantly for share investors, higher bond yields call into question the durability of the rally in US equity markets, although tax cuts are a powerful tailwind.
Last Friday’s release of October non-farm payrolls showing much lower than expected employment growth (albeit strike and weather affected) meant that the most likely outcome of the Fed’s meeting this week would be – and was – a 25 basis point (bp) cut to the policy rate taking it to 4.50-4.75 per cent.
However, the robust September payrolls combined with indications of “stickier” inflation from the September CPI report are a reminder that the Fed easing cycle could well be a cautious one (unless and until the Fed’s independence is reduced).
That will only be exacerbated by the potential inflationary consequences of Trump 2.0. It is clear that after the dust settles on the US Presidential election, the US bond market has a lot to think about.
And if that is the case, the reverberations will continue to be felt through the entire gamut of financial assets.
RBA: traversing the narrow path?
As expected, the RBA kept the policy rate unchanged at 4.35 per cent when it met earlier in the week. In its Statement accompanying the decision, the Board clearly outlined the rationale behind their stance while exhibiting an alertness to the risks around its central case scenario.
Put very simply, in the RBA view demand is still running ahead of supply, making for “sticky” inflation and until that state of excess demand is resolved, current policy settings will remain.
In her press conference, the RBA Governor implied that the Board focused on the question whether the policy stance was “restrictive enough” to return inflation to target without causing any severe dislocation in the labour market. Clearly, the answer was in the positive.
For what it is worth, my sense is that the Board thinks it won’t need to raise rates again this cycle but, given residual uncertainties around the “stickiness” of inflation (services inflation at 5 per cent), is reluctant to excite speculation in that direction.
In my view, the Governor struck the right (balanced) tone in her press conference.
Where the RBA has differed from other developed country central banks, is that it showed a reluctance to raise rates as far and as fast. The consequence has been a lower peak in the policy rate, relatively “stickier” inflation, but relatively better labour market outcomes (in terms of the rise in the unemployment rate).
And that means that in Australia, policy rate adjustments on the downside will lag those in other developed countries.
Economic developments since the last meeting have by and large vindicated the RBA “experiment”.
Inflation appears to be declining more or less in line with the RBA August projection. The November projection issued on Tuesday shows a very marginal acceleration in the expected rate of disinflation.
Importantly, given the Board’s dual mandate, the labour market has shown resilience, and that resilience is forecast to continue, albeit with some slight rise in the unemployment rate.
That said, and as the RBA Board has acknowledged, there is a risk that the “pickup [in household spending] is slower than expected, resulting in continued subdued output growth and a sharper deterioration in the labour market.”
There is, as yet, no evidence of that “sharper deterioration in the labour market”.
Nevertheless, such deterioration is a non-trivial risk and one to which the RBA would certainly need to respond.
In my view, the RBA may soon be in a position to see some light at the end of the tunnel on inflation and may well avoid any dramatic dislocation in the labour market.
The most recent NAB Business Survey revealed some “straws in the wind” that inflation has stepped down in a manner that will allow the RBA to more confidently judge that inflation is heading sustainably back to target in line with the forecasts issued on Tuesday.
If, as I suspect, labour market outcomes and inflation outcomes are broadly in line with RBA forecasts, then the RBA could conceivably cut rates in February.
That said, challenges remain.
As worthy as the RBA “experiment” may have been, inflation is still indubitably “sticky” – more so than in the rest of the developed world. And the RBA’s inflation containment task continues to be frustrated by counter-productive government policies.
With a Federal election expected in the first half of 2025 that might well continue.
So, while February remains a good guess for the first policy rate cut in the cycle, the various challenges confronted by the RBA, including those thrown up by governments, mean there is a risk that the reduction will come later.
However, despite those challenges, the RBA “experiment” appears to be negotiating that metaphorical “narrow path” between declining inflation and minimising labour market dislocation, and doing so in a much better manner than many of its peers.
Stephen Miller is an Investment Strategist with?GSFM. The views expressed are his own and do not consider the circumstances of any investor.