If this post-election economic growth scenario that we discussed in our post last week (see “The Election Impact on High Yield: Rates and Regulation, Interest Rates and the Economic Outlook”) were to become a reality, potential inflationary pressures could mean that the Fed would be more aggressive in increasing rates, and we are already seeing the various securities on the Treasury yield curve reflect this possibility. The Federal Reserve directly controls the Federal Funds Rate, a short term intra-bank lending rate. However, expectations of its movement and market forces impact US Treasury rates, which, as we noted above, were 1.83% on the 10-year the day before the election and now have touched above 2.3%—a 50bps move.1 Will rates keep moving up? We believe the market has overacted over the past few weeks and wouldn’t expect a dramatic move upward from where we are now.
There are a few important factors to consider. First, no matter who the president is or how much government spending/tax reductions are applied, it doesn’t change global demographics. We have an aging population domestically and worldwide. As people age, their investment focus tends to shift from capital appreciation expected from equities and instead favors income generation and capital preservation—which fixed income securities can provide. With this demographic reality, pension plans are likely to continue their concentration on matching assets and liabilities, again which the fixed income market provides. Pension plans and retail investors alike are huge participants in the financial markets and we’d expect that given these continuing demographic shifts, these aging buyers will be shifting out of equities into fixed income over time. Additionally, the aging population will also have a negative impact on global demand, in turn lessening the need for the Fed to be aggressive with rate increases. Spending on everything other than healthcare tends to decline with age, which can serve to stall the growth story. For more on this reality, see our writings “Zero Sum Game” and “Of Elephants and Rates.”
Another consideration is the yield on medium and longer term US Treasury debt versus sovereign debt rates globally. How much can US rates dislocate from the rest of the world? 10-year bonds in much of the rest of the developed world are yielding around 0-1% and many of these economies are still in the midst of quantitative easing and stimulus.2
So comparatively, with our higher rates and better economic conditions, we believe this keeps buyers in our market. The dollar will certainly be a consideration for investors—but the dollar will be a consideration for the Fed as well as they look at how aggressive to be with rates.
Also keep in mind that higher rates can become self-fulling; in essence higher rates thwart growth and the need for rates to keep increasing. A key point of monetary policy is to manage economic growth as the Fed works to fulfill their mandate of keeping inflation in line. As growth declines, lower rates can be used to stimulate growth, and vice versa, as growth increases, higher rates can be used to slow whatever growth there is.
But this would assume we get to a scenario of moderate growth—an assumption that we still don’t believe is valid. Economic growth, lower taxes, an increasing inflation scenario and higher rates along with it are certainly not foregone conclusions. While the Republicans control Congress, it is only by a narrow margin in the Senate, so there may be some negotiation and moderation that may have to happen as they look to make a change to individual and corporate taxes and we would expect it to take some time. So ultimately maybe there is a reduction of taxes which may drive some consumer spending…or instead do consumers use it to repay debt or increase their savings after years of having to pull from it?
The “politics of rage” as it has been called is sweeping across the globe with elections in France and a host of European nations up next. Protectionism and nationalism are on the rise and none of this is good for global trade and growth rates. Rates have risen too far and too fast in our opinion. The Fed is very likely to hike rates 25 basis points in December to save any credibility. How many more rate hikes might be coming is certainly up for debate, but we remain skeptical. Eight years have passed since the 2008 crisis and we have seen trillions of dollars of stimulus force fed into the economy to what end? The election of Donald Trump is unlikely to change the course set for us by demography. Interest rate risk (duration) is now the fashionable topic but it will fade as quickly as it came.
We are not a believer in the rising rate script but remain vigilant and highly sensitive to the reality of stagnant global growth rates and an aging population. For more on our thoughts on the economy, rates, regulations, and the outlook for the high yield market as a result of the recent election, see our piece “The Election Impact on High Yield: Rates and Regulation.”
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