US fiscal policy has juiced bond yields, interest-rates and economic growth

The economic story of 2024 is again being driven by the US economy. Back on the 4th of this month we were ahead of the game.

The Bond market sold off in response to the above and the thirty-year yield has moved above 4.5%. Or if you prefer the bond market was not buying what Jerome Powell was selling. Money markets moved as well.

In fact the US thirty-year yield is 4.7% as I type this so the heat has been on in the meantime. Along the way it has been above 4.75%. There are quite a few consequences from this and let us start with the ones domestic to the US economy.

The IMF has warned the US that its massive fiscal deficits have stoked inflation and pose “significant risks” for the global economy.
The fund said in its benchmark Fiscal Monitor that it expected the US to record a fiscal deficit of 7.1 per cent next year — more than three times the 2 per cent average for other advanced economies. ( Financial Times)

I have pointed out before the dangers of using higher bond yields as a permanent signal as opposed to a potentially temporary one.But it is also true that the US economy has been juiced by quite a bit of fiscal stimulus under President Biden.

But the IMF said the US had exhibited “remarkably large fiscal slippages”, with the fiscal deficit hitting 8.8 per cent of GDP last year — more than double the 4.1 per cent deficit figure recorded for 2022.

This is a change for the IMF because when I recently looked at their database they were suggesting deficits more like 6% of GDP for the US. Interestingly they added an estimate of the inflationary impact of all of this.

The IMF said the country’s fiscal deficit had contributed 0.5 percentage points to core inflation — a measure of underlying price pressures that excludes energy and food.

Being the Financial Times there is an attempt to blame The Donald.

The presumptive Republican presidential nominee Donald Trump has pledged to make his 2017 tax cuts permanent, a move the Committee for a Responsible Federal Budget think-tank expects to cost $5tn over the next decade.

Whilst The Donald is a man of extensive debt experience he is not the President responsible for the surge in US borrowing. Also as I pointed out on the 4th of this month the Biden administration has been issuing debt in a risky way.

Back on the 26th of March I pointed out that the US is borrowing short by the issuance of lots of Treasury Bills thus making things more unstable.

So with bond yields higher things are both riskier and more expensive in the long-term. Also those looking for a mortgage will be facing higher interest-rates.

The bad times keep rolling for mortgage rates with the average conventional 30yr fixed rate back up to 7.5% according to our daily index.  ( Mortgage Daily News on Tuesday)

In the end this all depends on economic growth as along the way decent growth fixes pretty much everything.

IMF FORECASTS US 2024 GROWTH AT 2.7% VS 2.1% IN JANUARY FORECAST; 2025 GROWTH AT 1.9% VS 1.7% IN JANUARY ( @FirstSquawk)

Problems will arise pretty quickly should growth stop though.

Problems for Jerome Powell

The Chair of the US Federal Reserve was at the IMF meeting and used it to give his view.

Powell on Tuesday signaled the Fed will wait longer than previously anticipated to cut borrowing costs following a series of surprisingly high inflation readings — marking a notable shift from his December pivot toward easing. ( Bloomberg)

That was rather awkward for him personally. But we have been guided towards interest-rate cuts in March and then June and now we will get neither. As we seem to be progressing quarterly that now brings September into the frame. Except then we will be in the election campaign I am sure The Donald will be all over the implications of any interest-rate cuts for that.

Looking at the economics what makes me uncomfortable is that central bankers are again looking backwards to past inflation prints when the real issue is what will happen in 2025/26. They are what it can influence but they keep doing this.

I keep forgettin’ we’re not in love anymore
I keep forgettin’ things will never be the same again
I keep forgettin’ how you made that so clear
I keep forgettin’ ( Michael McDonald)

The US Dollar

The factors above mean we have returned to the phase of King Dollar

The US dollar is on track for its best 5-day run since February 2023. The Bloomberg Dollar Spot Index has risen by ~2% over the last 5 trading days, the most in 14 months. Meanwhile, the US dollar index is up ~5% year to date. ( KobeissiLetter)

This has tightened the noose on everyone else just as 2024 was supposed to be the year of lower interest-rates and a weaker US Dollar. Yet we have instead seen this.

• The Japanese Yen has continued to show weakness against the U.S. Dollar following last week’s USD/JPY breakout to fresh 34-year highs. ( forex.com)

In Japanese terms this is awkward on several levels. Their change to a positive interest-rate was supposed to calm things. Then Finance Minister Suzuki indulged in some open mouth foreign exchange interventions. As we stand at 154.25 he has only succeeded in putting his foot in it.

Whilst the situation is not as acute in Europe many central banks there are in the process of having itchy shirt collars due to the strength of the US Dollar. The ECB has guided people as directly as it can towards an interest-rate cut in June where it expected to be accompanying the Federal Reserve. The Swedish Riksbank guided towards May or June. Both will now fear further currency weakness and in an irony might even welcome this.

Purposely devaluing the U.S. dollar by pressing other countries to alter their own currency values would represent the most aggressive proposal yet in Trump’s attempts to reshape global trade……… A weaker dollar would make U.S. exports cheaper on the world market and potentially reduce the U.S.’ yawning trade deficit. ( Politico)

I mean the policies as in an extraordinary statement for a central banker President Lagarde has expressed her hatred of The Donald more than once. The problem with this is that any Dollar decline is likely to come quite some time after the ECB wants ( and indeed needs) to cit Euro area interest-rates.

Comment

There are clear elements of groundhog day here as in some ways we have gone back to last autumn. Higher bond yields leading to fears about the US deficit. Stronger US growth giving us a higher Dollar and so on. Actually also for the Federal Reserve where “higher for longer” which was only a PR phrase has returned.

Some of the implications are welcome, for example US economic growth. But there are risks as we wonder about those who borrow in US Dollars? Plus there are the issues with US regional banks and commercial property. Other countries need interest-rate cuts due to weak economic growth but now also have currency risks. Plus there is the US itself as its numbers will deteriorate fast in the next recession. Which makes fiscal stimulus even more likely as it strives ever harder to avoid it.

“It takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!” (The Mad Hatter)

Why is no-one else questioning the Bank of England QT programme?

Whoever is presenting the virtual morning meeting at the Bank of England today probably could not believe their luck as they saw Sky News reporting on a forecast that UK house prices will be 18% higher in 2028. Few things are as likely to put Governor Andrew Bailey in a good mood especially if they remind him again of this from yesterday.

“UK house prices rose in October, up +1.1% on a monthly basis, breaking a run of six consecutive monthly falls.
The average house price is now £281,974 – an increase of almost £3,000 compared to the previous month” ( Halifax)

They might like to skip the annual decline of 3.2% although it had improved from the previous 4.5%. Of course you can forecast pretty much anything five years ahead, and many do, as who will even remember? But things are swinging in that direction at the moment with the UK five-year yield falling below 4.25% suggesting some cheaper mortgage deals are on their way.

Chief Economist Huw Pill

One factor in the bond yield move was this on Monday evening.

LONDON, Nov 6 (Reuters) – The Bank of England might wait until the middle of next year before cutting interest rates from their current 15-year high, the BoE’s Chief Economist Huw Pill said on Monday.

Pill said pricing in financial markets – that currently points to a first rate cut to Bank Rate in August 2024 – “doesn’t seem totally unreasonable, at least to me.”

“It is at that point you might consider or reassess, if nothing new has happened, where we are going to have to be,” Pill said during an online presentation organised by the BoE.

That was rather a change and sadly rather means that Huw Pill has made a bit of a fool of himself again. Here are his words from the 31st of August via The Guardian.

“There may be multiple paths that get you to where you want to be,” Pill said in his speech. “Some of them have rates rising rapidly and falling rapidly in what is sometimes known as the Matterhorn profile.

“The alternative would be to hold restriction for longer in a more steady and resolute way with a profile for interest rates that looks more like the Table Mountain. I would tend to favour the latter.”

Pill’s comments suggest he will be voting for official borrowing costs to be raised again – from 5.25 to 5.5% – when the MPC meets later in September but then may well opt for them to stay on a plateau for some time to come.

Actually Huw managed to give the wrong impression on how he was going to vote three weeks later which has become something of a theme for him. But the real issue for today is that his Table Mountain or “higher for longer” has not actually lasted very long at all. I did warn at the time. From the 1st of September.

The reality as we have seen with so many other issues is that as used to be said in films about cowboys and indians “you speak with forked tongue”

The issue here is that markets will run ahead of the words used. So whilst Huw says interest-rates may be cut in August 2024 they think that it will be earlier. We are already seeing real world consequences of this with the fall in bond yields I mentioned earlier in this piece and the likely fall in mortgage rates. Of course the moves have not been entirely due to Huw but there has been something of a generic central banking pattern here.

One more troubling thought is that Huw has been so consistently wrong that this may be wrong too! Or that he provides his real views to his former employer the Vampire Squid.

Governor Andrew Bailey

The Governor’s good mood will have been enhanced by the opportunity to have his breakfast paid for. Although as he is in Dublin I do hope he refrained from asking for a Full English. Anyway he has added to the debate with these words in addition to the speech.

 **EXPECT NEXT INFLATION READ TO BE QUITE A BIT LOWER **EXPECT IT TO BE QUITE A BIT LOWER BY YEAR-END, NOT DOWN TO 2%

**WE THINK POLICY IS NOW RESTRICTIVE, ECONOMIC GROWTH VERY SUBDUED

**BASIC MESSAGE IS THAT WE BELIEVE POLICY WILL NEED TO BE RESTRICTIVE FOR EXTENDED PERIOD, THERE ARE UPSIDE RISKS

**REALLY TOO EARLY TO BE TALKING ABOUT CUTTING RATES  ( @PiQSuite )

He has really rather mixed up his messages here because the “higher for longer” claim is contradicted by the talk of lower inflation and economic growth being “very subdued”. The denial about “cutting rates” will be read as that is already on his mind.

The ongoing QT disaster

This is an area where the media seem to be giving the Bank of England pretty much a free pass. In simple terms having bought UK bonds at the top of the market it  has been selling at what looks may well have been the bottom. Here is an example of what I tweeted on Monday afternoon.

The Bank of England has sold another £670 million of its UK bond holdings this afternoon. The bonds sold mature between 2044 and 2068. The 2050 bond which it was buying around 100 was sold for 37.2

These are extraordinary losses and the taxpayer has already been called on for £24 billion. But I seem to be the only person questioning it.

The next issue is how long they may do this for? We can start thinking about this via a speech from Andrew Hauser from last Friday.

Taken together, these schemes saw reserves reach a peak of
nearly £980bn at the start of 2022. That’s equivalent to 40% of annual UK GDP and is more than fifty times the level in Autumn 2006, when reserves were just £17bn.

As you can see the credit crunch era has led to extraordinary changes in the Bank of England balance sheet. But the reality now is that the financial world has adapted and now depends on much of it. Or if you prefer Five Star nay have been more prescient than they realised.

System addict
I never can get enough
System addict
Never can give it up, oh oh, no oh

One lesson of the credit crunch is that banks needed to have ready access to more liquidity. Applying that suggests this.

In response, banks have since 2013 been required to hold sufficient liquidity buffers to cover 30 days of stressed outflows, calculated by applying a set of weights
representing a particular scenario to each type of bank liability. The sum of these socalled ‘Liquidity Coverage Ratio (LCR)’ requirements across SMF banks’ sterling deposit liabilities currently amounts to some £570bn.

That is not the only way of calculating the numbers as there is also this.

The latest aggregate PMRR estimate from this
exercise is £335-495bn.

But as you can see there will be an end to QT sooner than some might think and on one scenario quite a bit sooner.

The problem for the Bank of England is that this makes its rush to sell assets and what so far is at or near the bottom look even more ill-conceived.

Comment

The supposed technocrats have essentially two levers to pull and they seem to be in a mess on both. Having ignored the rise in inflation via their “expert” analysis they are now promising interest-rates “higher for longer” when the outlook is now very different. If we now switch to their policy on QT they seem determined to create as many capital losses as possible.

Also we can go deeper as the whole QE effort changed the financial system and much of it now looks permanent. Why am I the only person asking for an assessment of what it achieved and now what the costs are? These are issues I have raised consistently over the last decade and more. Indeed I remember writing a piece in City-AM back in September 2013 when I suggested we should do some QT which would have been at far better levels than now.

Let me finish with some number crunching as Andrew Hauser have some figures on the size of the UK financial system.

There are currently £3.2 trillion of sterling sight and time deposits held at banks that are members of the Bank’s Sterling Monetary Framework (SMF) – nearly 50% higher than mid-2006. Within that, sight deposits – which are the easiest to withdraw, and hence a key source of short-term liquidity risk – are currently £2.1 trillion.

 

What are the consequences of US bond yields rising above 4.5%?

This morning the heat is on and it comes from a source that you might nor expect as investor’s minds turn towards when the central banks will start easing policy. Actually in a way it is a reversal of the response to the credit crunch. Back then we saw interest-rate cuts which were followed by QE bond buying to lower yields. Now we have seen interest-rate rises and maybe the balance sheet reductions ( for example the Bank of England sold another £650 million yesterday) have led us to this.

10-Year Treasury Yield moved up to 4.55% today, highest since Oct 2007. ( @charliebilello )

Others put it in more clickbait fashion.

BREAKING: Bond tracking ETF, $TLT, falls below $90 for the first time since April 2011. The 10-year note yield is now trading above 4.50% for the first time since 2007. The 2-year note yield is now up a massive 500 basis points since September 2021. Treasury yields are hitting 15+ year highs daily now as Fed pause expectations go well the second half of 2024. ( The Kobeissi Letter )

There is quite a bit going on as this applies pressure in a lot of areas. We can start with the US itself where borrowing for the US government is getting more expensive and it is not the only one.

For the average lender, a top tier 30yr fixed rate is now over 7.5% for the first time in at least 22 years.  The average borrower (not “top tier”) is seeing rates that are even higher.  ( Mortgage Daily News)

With yesterday’s push higher in bond yields maybe more is to come. Although care is needed as we have two different situations here. New buyers and those refinancing are being hit but due to the existence of 15 and 30 year mortgages the effective rate for the overall market is between 3.5% and 4% due to some many (wisely) being taken out at cheaper yields.

King Dollar

It could not be much clearer here.

LONDON/SINGAPORE, Sept 26 (Reuters) – The dollar rose to a new 10-month peak on Tuesday as U.S. bond yields surged to their highest level since October 2007, while the Japanese yen resumed its slide, putting traders on alert for signs of government intervention.

The Japanese Yen has gone through 149 and the Euro has gone to a 6 month low.

The euro was last roughly flat against the dollar at $1.0588, after hitting its lowest since March at $1.057.

So the international consequence is another phase of US Dollar strength which makes everyone else’s inflation problem worse. Another issue is that the interest-rate rise from the ECB a week or so ago has not helped here.

What is causing this?

One potential factor is the Higher for Longer theme of the US Federal Reserve.

Sept 25 (Reuters) – Minneapolis Federal Reserve Bank President Neel Kashkari said on Monday that given the surprising resilience of the U.S. economy, the Fed probably needs to raise borrowing rates further and keep them high for some time to bring inflation back down to 2%.

Although if you listened to the words of central bankers you would be long US bonds at the top and now selling at the bottom!

Next up is the borrowing of the US government but that has not really changed although there are again shutdown fears.

“A shutdown would be credit negative” for the U.S. debt, while “A shutdown “would underscore the weakness of U.S. institutional and governance strength relative to other Aaa-rated sovereigns that we have highlighted in recent years,”  Moody’s analysts wrote.

The credit rating firm added, “In particular, it would demonstrate the significant constraints that intensifying political polarization put on fiscal policymaking at a time of declining fiscal strength, driven by widening fiscal deficits and deteriorating debt affordability.” ( CBS News)

This is one of those spiraling issues as higher yields cause wider deficits and weaker debt affordability.

Hedge Funds

There seems to be another factor in this scenario as the Financial Times explains.

Over the past month, the Bank for International Settlements, a convening body for the world’s central banks, and the US Federal Reserve have both pointed to a rapid build-up in hedge fund bets in the Treasury market.

The so-called basis trade involves playing two very similar debt prices against each other — selling futures and buying bonds — and extracting gains from the small gap between the two using borrowed money.

On a tactical level there is no risk here because your futures position should be the mirror image of your cash bond position. It is also nothing new as I recall watching traders do such trades in BTPs on the LIFFE floor in the 1990s. That was very old era technology as they were on landlines connected mostly to Milan to trade cash Italian bonds against the futures in London. It is always Italy isn’t it? Actually it is the higher interest-rates which bring this into play again in the US  which was true of Italy back then with the addition that the frenetic nature of the Italian bond market added to the risk but also potential profits.

The problem is not this per se as someone getting the wrong way on a particular deal may not be significant. But if we switch from tactical to strategic we see that the size of the trades might be an issue.

By taking advantage of the ability to borrow on both sides of the trade, hedge funds can deploy huge leverage. The head of one fund that has engaged in this trade says traders have in the past been able to lever up to 500 times.

Ah leverage of 500 times! What could go wrong?

For them now we have another bit of central banking influence they think very little as thy have a backstop.

In such a situation, it would be highly unlikely for the US central bank to simply stand back and watch. The executive at the large US bank says: “The assumption is that the Fed will step in to save the repo market, which they have in the past, so my view is that they will step in again if anything happens.” ( FT)

Actually what you are creating is the possibility of an enormous whipsaw as this happens first.

Regulators say this all adds up to a situation where just a few large firms getting out of their bets could potentially encourage or force others to do the same, quickly leading to a doom loop of distressed selling in the world’s most important asset market. ( FT)

Comment

In a way a lot of this comes from the consequences of the largest financial punt in history. That was when the central banks surged like headless chickens into the world’s bond markets and not only pushed them to all-time highs but bought at the top. That helped create the inflation that forced them to raise interest-rates and reduce their balance sheets and so  effectively sell bonds at the bottom.

In that scenario we see how bond yields have risen. But there is another factor at play which further raises the risk of the basis game. QE has reduced bond market liquidity as so many players were punished. Think of what the ZIRP equivalent for bond yields did to pension funds and insurance companies?! All the 2020 and 2021 purchases now look awful. In a sense we are back to this again.

Does anyone know the way?
Did we hear someone say
“We just haven’t got a clue what to do!”
Does anyone know the way?
There’s got to be a way
To Block Buster! ( Sweet)

Now as we are seeing a bit of a panic let me give you the other side. Buyers of US Treasuries are getting 4.5% which is 4% or so better than 2020. Next up is those wondering that the central banks have little alternative but to buy it all again, however much they might deny it.