Debt Emergency Looms Large
Reflections on the Current Situation
With less than a week left for the United States to select their next President, the political discourse seems to be at a critical juncture. The choice of words here is deliberate, as one of the options being considered is a more isolationist approach towards trade and foreign policy. This approach could see the US stepping back from its leadership role and pushing its often reluctant allies to shoulder more of the global security burden.
This could signify the end of the 'Team America World Police' neocon phase, or even the 'making the world safe for democracy' ideal if one looks further back in history. It is now apparent that the bond market and the DXY are becoming increasingly sensitive to the potential implications of another Trump win.
Implications on the US Economy
US 10-year yields have fallen nearly 3bps overnight, but have risen over 55bps since the Federal Reserve cut rates in mid-September. Americans who were waiting for rate cuts before buying houses are now facing mortgage rates beginning with a 7-handle, as US mortgages are typically priced off the long end of the yield curve.
The curve's shape is revealing. While the OIS futures strip has reduced prospects for further rate cuts from the Federal Reserve this year, the 2s10s Treasury spread has continued to steepen. The 2s10s was still inverted at the beginning of September, but now records a positive slope of 15.5bps even as the whole curve has shifted higher. Interestingly, the 2s30s spread has not steepened at all since the Fed cut rates.
What Does This Mean?
In essence, markets are betting on fewer rate cuts in the near term and a decade ahead where inflation may be higher than we have been used to in the recent past. This could be due to improving odds of a Trump election win, causing markets to re-price assets to reflect a world where Trump's policies are implemented. Trump is known for his big spending, sweeping tax cuts, and universal tariffs, which most economists would argue are inflationary. However, a Trump win isn't the only bear case for bonds.
There is also a renewed concern over the global debt burden and the likelihood of that burden growing further as nations face higher spending on health, aged care, national defense, and interest expenses.
Implications on Economic Theory
The recent price action seems to support the Rational Expectations Theory, but other elements of economic theory are also gaining traction. The concept of low but stable inflation targets being beneficial stems from the idea of 'nominal rigidities'. This suggests that certain prices in the economy are 'sticky', and markets are therefore not self-equilibrating as classical economists might suggest.
Examples of this include the decline in US home sales volume as sellers refuse to adjust price expectations to match current economic conditions, and the proposed 10% wage cut for Volkswagen autoworkers in Germany due to Europe losing the competition race to China.
In both cases, market offers have remained sticky and not adjusted to economic realities. The bid/offer spread has widened, and transaction activity has dried up. New Keynesian economists, who dominate central banking and national treasuries, propose solving this problem by creating enough inflation for bid prices to rise to meet these sticky offers.
Future Implications
Hints of this kind of thinking may be seen later today when UK Chancellor Rachel Reeves delivers her first budget. Chancellor Reeves is expected to redefine how the UK measures debt so that it can borrow more to "invest". The UK already exceeds the 90% debt-to-GDP threshold estimated by Carmen Reinhart and Ken Rogoff to be the point where the Keynesian multiplier falls below one. This means that for every extra dollar the government spends, GDP increases by less than one dollar, making borrow and spend stimulus measures self-defeating as debt grows faster than GDP.
The options to escape this economic doom loop are default or retrenchment (austerity). However, austerity is unlikely to be proposed seriously by any government after previous attempts severely frayed the social contract. On the default side, countries without control over their own currency issuance are limited to hard default, while sovereign currency-issuing governments can default subtly by debasing their currency.
This is the financial repression scenario where bondholders finance fiscal profligacy by holding securities that yield negative real returns. Under this scenario, the smart money moves out of bonds and into real assets that provide an inflation hedge. With the S&P500 up more than 22% YTD and long yields rising, is this the future that markets are now envisioning in what is beginning to look like a debt emergency?
Bottom Line
The current economic situation seems to be pointing towards a potential debt emergency. The implications of this are far-reaching and could significantly impact global economies. What are your thoughts on this matter? Do you agree with the analysis presented? Share this article with your friends and let's get a conversation started. Don't forget to sign up for the Daily Briefing, delivered every day at 6pm.
