MUNIX COMMENTARY – WEEK OF 4 January
This was an important week for the US government bond market, the largest and most liquid benchmark for the western world. The US 10-year yield broke up through 1.0% for the first time since March. It had already been under some pressure. The latest business surveys showed surprisingly strong expansion in manufacturing sectors, not just in the USA but around the world. Inflation expectations had also been deteriorating, partly due to the slow decline in the US dollar and the rise in raw material and transports costs. OPEC is supporting oil prices above $50 per barrel while copper prices have risen to their highest since 2013.
Politics, however, was the straw which broke the camel’s back. 2021 was always likely to match 2020 as being a year when political news could, at the very least, create short term volatility, and even have the potential to create major swings in investor sentiment and market movements. The two US Senate elections in Georgia fall into that camp. At the end of a tumultuous 48 hours in American politics, their impact was more important than the shock of a riot in the US capital.
These seats matter, as they determine whether the Republicans or the Democrats have a small majority in the Senate – which in turn is so important under the US Constitution for controlling, disrupting, or enhancing the President’s legislative agenda. If the Democrat victories are confirmed – and we can expect a series of appeals as the results are tight, a few thousand votes – then whenever there are 50-50 splits over items such as Budget resolutions, so President Elect Kamala Harris would have the casting vote. Going into the weekend, the opinion polls had shown a tight race but on balance the Republicans were expected to retain at least one if not both seats. Perhaps the Washington Post’s release of Donald’s Trump’s phone call with the officials in Georgia about whether the Presidential election was stolen did tip the balance.
The impact on the bond markets was clear. New news about potential issuance and stimulus spending had to be priced in shortly after Congress agreed to a further $0.9 trillion package to support the US economy in the first few months of the year. Now the markets must start to consider the possibility of even larger bond issuance in coming months. Back on the table immediately will be the debate about $2000 cheques to American households, followed by significant support for state and local governments to cope with the pandemic and vaccination programmes.
How will equities respond? This is less clear cut; on the one hand there is a greater prospect of much larger stimulus programmes – Biden was talking of $5-10 trillion figures rather than the recently agreed $0.9 trillion package, while he will have more leeway on his grand plans for tackling climate change or boosting America’s infrastructure. It must be noted though that not all Democrat senators are signed up to radical “Green New Deal” spending programmes, reflecting the differences between moderate and progressive Democrats. As ever, the devil will be in the detail. On the other hand, higher bond yields will affect the valuations of expensively priced shares, while there is the prospect of higher corporate and income taxes to pay for the President’s largesse. The Democrats have also argued for much tougher antitrust rules on the technology sector. Hence, there may be a flight to safety from equities back into bonds once again.
How far might US bond yields rise? If 1% does become the floor, and it held despite events in Washington, then in technical terms 1.25% is seen as a strong ceiling. Whether such levels are tested will partly depend on economic news – how strong or weak is the US economy into the spring will partly depend on the efficacy of the vaccination programmes. Further moves in US bonds will also depend on whether the Federal Reserve decides to increase the pace of its Treasury purchases, or more formally adopt yield curve control, on the grounds that there is a risk that rising yields could choke off the recovery. This would require a change in view amongst some central bankers; for example, a few days ago Chicago Fed President Charles Evans indicated “If the recovery was slower, I think we’d still be having interest rates at the zero lower bound, but I think we’d also be following it up with more asset purchases”. Other Fed speakers recently talked about Fed policy being “well calibrated”. Cleveland Federal Reserve President Loretta Mester has stated that the central bank could continue its asset purchases through all of 2021 even if the economy improves in the second half of the year.
Of course, to quote Keynes – or perhaps it was Samuelson or Churchill, the actual attribution is uncertain – “when the facts change, sir, I change my mind”. Central bankers have shown in recent years how very flexible they can be, as have the voters in Georgia who had resolutely voted Republican all the way since 2000 – until November 3rd and today.
Andrew Milligan is an independent economist and investment consultant. This note should be considered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making