Mirkamil Galip

Columnist

mirkamil.galip@edhec.com

Focus on Macro

According to ZeroHedge, 93% of all asset classes traced by Deutsche Bank posted negative returns for 2018 as of 20th December, making it “The Worst Year on Record” based on data back to 1901. It’s worth mentioning that just in the previous year, the aforementioned ratio was only 1%; the dramatic turn of the financial markets was obvious. In 2019, the major risks for US economy are mostly still in prevalent.

One of the main reasons for the economic downturn in 2018 is the tightening policy taken by the Federal Reserve. The Fed has been undergoing balance sheet normalization for a couple of years. Last year, the Fed has raised interest rates 4 times, raising it from 1.5% to 2.5%. The effects have been significant, given that most of the growth during the past decade is attributable to the low rate environment. Now the QE era is over, the turning point has come, and 2018 can be seen as the critical year that sets the tone for the coming years.

Figure 1: Market-implied Probability of December 2018 Rate Hike

Figure 2: Market-implied Rate Probability for 20 March FOMC Meeting

“Inversion” of the Yield Curve

A few weeks ago, the Fed changed its hawkish tone and adopted a more hesitant attitude towards rate hikes, or put another way, they are becoming more “data-dependent”. This uncertainty leads to a major risk. Fed has to be more careful than ever on its policy decisions. Once the Fed makes one wrong move or shows any sign that it doesn’t have things under control, the market will release the long-awaited pessimism, just like the panicked selloff known as the Taper Tantrum caused by the announcement of Fed’s tightening policy. The butterfly effect that might follow could lead us to even bigger troubles. The market consensus for 2019 rate hikes has been swinging. It is unclear how many hikes we will face this year.

On 3rd December 2018, the yield to maturity of 3-year bond and 5-year bond inverted, which means the return of investing in the short-term bond became higher than that of the long-term bond. This is a significant event that hasn’t happened for 11 years, i.e. since the financial crisis. The short end of the yield curve is decided by the Fed policy, while the long end is decided mostly by the market. The inversion on the yield curve often indicates a pessimistic expectation for the economy and is often followed by a recession. The Fed might have risen rates too quickly in the past year, and investors are demanding a lot of safety nets at the expense of higher return. What makes it less frustrating is that the spread between the 2-year bond the 10-year bond, which is used as a more formal indicator, is still positive. The warning sign was clear, but the “real inversion” hasn’t happened yet.

However, when taking into account the context of soaring government debt, the result will become more worrying.

Figure 3: Historical Relationship between Yield Spreads and Recessions

Figure 4: Federal Debt Held by the Public

Figure 5: Average Maturity & Percentage of LT-Bonds

US Federal Deficit, the Elephant in the Room

The federal government has long been spending much more than it takes in. To finance the persistently huge deficit, the government has accumulated an enormous amount of debt, which is still increasing and shows no signs of slowing down.

According to the data available at CBO, government debt has reached the highest level since the World War Ⅱ. The government has been supplying investors with huge volumes of bond issuances. In 2018, the federal government issued $1.3 trillion of new debt, rising 146% from the previous year.  Besides the surge in the volume, the debt has also become longer term. The average maturity of bonds has gone up from the pre-crisis level of 50 months to today number of around 70 months.

The volume uptick combined with the lengthening of maturity would push up the long end of the yield curve. If it weren’t for the “artificially high” long term yield, we might have witnessed a full inversion instead of a quasi-one.

However, this is unlikely to be the end of debt explosion. The deficit is projected to remain at a high level for quite a long time.

One major reason for the surging deficit is Trump‘s Tax Cut and Jobs Act of 2017. The tax cut started with Trump’s many promises, and tons of oppositions. On 2nd December, 2017, the Senate version of the bill, the last critical step before it officially became law, passed with the smallest possible majority: 51-49, with all Democrats and one Republican voting against the bill. The dramatic scene was one of the iconic moments of Trump’s controversial policy. Trump claimed the tax cut would pay for itself, since it would unleash the economic growth. It was indeed theoretically possible if the tax rate falls on the right side of the Laffer Curve. Yet IMF soon pointed out that, historically there were few examples succeeded in raising revenue while cutting taxes. Goldman Sachs estimated that the tax cut act will result in $1.5 trillion of net cost over the next 10 years.

In the past year, we have seen the tax cut boost the US stocks as well as the labour market, but it surely did not pay for itself. As expected, many of the promises were not achieved. The GDP growth didn’t reach expectation, and the situation is unlikely to improve as the stimulus gradually fades away. According to Tax Policy Center, the average tax rate will return to pre-tax-cut level by 2026. The business investment also falls short, as corporations used the tax savings mainly to pay out dividends and repurchase stocks. Now with the increasing deficit and huge amount of government debt, under the rising protectionism, the US might have an even harder time attracting investments.

While the revenue decreased, the government spending has increased during the past quarters. Mandatory spending, including social securities and Medicare spending, account for the biggest part of the outlay. Since the beginning of his presidency, Trump tried to kill off Obamacare to reduce spending, and despite all the effort, he failed. Now it’s only harder for Trump to make more legislations, under the current divided Congress. The interest expense, on the other hand, is also becoming a serious burden. Given all that, spending will probably not have a meaningful decrease for the coming years.

The rising debt has already become a dark cloud hanging above the US economy. And it’s set to remain at a high level for a long period. It’s definitely not normal during a time neither of war nor of recession. Yet it still did not gain enough attention. On 1st March, the bill signed by Trump suspending the debt ceiling will expire. That means if the debt ceiling isn’t raised before that, there will be no new bonds issued by the Treasury. We can expect a new round of political debate in Congress, as well as more volatility in the US bond market. There could also be a second shutdown of the federal government in a single year. Whatever the case, it has already become a dangerous situation.

Conclusion

With the tightening of financial conditions, the market will be consistently under pressure. Fed‘s decisions are now especially critical. It has to be extra careful on every step of the way. However, the growing national debt is putting the Fed in an even more difficult situation. It does not only increase potential default risks, but also leaves Fed with less options to manoeuvre when it needs to engineer a soft landing. If the US doesn’t come up with an effective measure to deal with the surging deficit and debt, it will become more and more dangerous as time goes on. With the 2020 election on the horizon, it’s possible that Trump will take more extraordinary measures. Although the Fed is supposed to be independent of political forces, it’s unlikely that it can stay immune if Trump continues his attacks. It is uncertain if2019 will be a pleasant year for investors.

Sources:
  • St. Louis Fed, CBO, US Treasury, CME, ZeroHedge, IMF, Goldman Sachs, Tax Policy Center, Bloomberg, Business Insider, Financial Times
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