The prospect of a steeper yield curve next year is becoming a focal point in financial discussions. 2023 marks the first time in a decade that the yield curve has remained inverted for the entire year, with this trend starting in July 2022. An inverted yield curve is traditionally seen as a sign of an impending recession and typically, the curve tends to steepen as a recession starts.
Throughout 2023, the market experienced an inverted yield curve in the 2-10 spread, starting and ending around -0.5%. The inversion deepened beyond -1% at times, notably in March and June last year.
Chart 1: Spread between 10-year and three-month US treasuries
Recession or a Slowdown?
Strategists predicted a recession last year but ultimately ended up being wrong with both the economy and the consumer proving resilient.
The job market is currently undergoing a rebalancing process and whilst the expansion of job growth has slowed, this trend is not causing much concern. The number of job openings remains higher than the levels observed in 2019 across almost every industry, indicating that labour demand remains robust and hasn't drastically declined. One explanation for the higher number of openings is more focused hiring in certain industries, such as healthcare, hospitality, and government. This has resulted in a larger-than-average increase in wages that has helped to attract new labour easing supply constraints.
The chart below highlights the number of job openings vs. the number of unemployed in the US economy. Anything above 1 implies more jobs than unemployed to fill them.
Prior to the January jobs report, there was an indication that the labour market was beginning to loosen, evidenced by a decrease in both the quit rate and wage growth. Nonetheless, the robust job gains in January contributed to the soft-landing thesis. Presently, there are still more job openings than unemployed people looking for work and, despite the January jobs report, we do believe the ratio is likely to move towards equilibrium by the middle of the year.
The ‘Sahm Rule’ derives one of its variables from labour and is a popular new Federal Reserve indicator designed to signal the onset of recession when the unemployment rate increases by 0.5% relative to its 12 month low. The rate had been showing an upward trajectory leading some strategists to call a recession. This trend, however, was promptly reversed following the release of the January job figures.
This all leads this economic environment to be particularly difficult to forecast. US labour shortages coupled with earnings being largely positive vs, consensus gives a compelling case for remaining invested in equity markets.
Why the slowdown?
Going into 2024, I see three key tailwinds diminishing: reduced fiscal spending, a strong consumer base, and China's reopening, all of which contributed positively in 2023. For the first time, US debt sustainability has become a focal point among American politicians. Vivek Ramaswamy, for example, has tried, albeit unsuccessfully, to campaign for the presidency with a mandate centred on reducing the national debt.
US Debt Sustainability
US Treasuries are offering more attractive yields than in the past five years, leading to a shift away from the mantra around “TINA” or “there is no alternative”, which refers to equity markets being the only place where investors can make money. This change is drawing more Americans to treasuries, a trend we saw highlighted in the Wall Street Journal headline “Stock bull markets helped make boomers rich. High bond yields are helping them retire.”
https://www.wsj.com/personal-finance/retirement/income-investing-bonds-dividend-stocks-01a97372
The interest in US treasuries, by the American public is fortuitus for the Fed, given demand from international buyers has waned. Both China and Japan have both cut their holdings on aggregate of almost $3 trillion in 2013 to under $2 trillion today.
Higher interest rates have raised concerns about debt sustainability, as they are higher than those seen in the previous market cycle. Additionally, the expected large issuance of treasury bonds and Quantitative Tightening (QT) could potentially create a supply imbalance, further questioning the sustainability of debt.
However, we remain less worried about higher rates and are more concerned about higher debt levels coming from larger deficits. Which could be dangerous for the public debt path, particularly in the US where the debt to GDP ratio is expected to diverge from Europe.
The “Growth in a Time of Debt” paper by Reinhart and Rogoff indicated a relationship between slower GDP growth when national debt to GDP was above 90%. Whilst this theory has since been debunked, the question remains as to whether governments can get away with pseudo Modern Monetary Theory when other governments are remaining fiscally disciplined.
In 2023, the US saw public debt interest repayments hit $1.3 trillion, or 4.6% of its GDP, a figure that is expected to rise, even with the possibility of interest rate cuts later this year. Oxford Economics projections indicate that the budget deficit may increase to 10% of GDP by 2050.
In addition to continued deficits, Oxford Economics draw two conclusions. Firstly, the impact of higher rates may be less severe than anticipated even if 10-year government yields remain elevated. Secondly, the more significant impact is more likely to be felt through budget deficits. A permanent 1% GDP increase in budgetary spending would likely raise debt to GDP by 30% by 2050, which on their debt path projector looks likely to reach 220%.
Unlike the US the debt paths in most major European economies looks more favourable, thanks to generally lower long-term rates as well as smaller budget deficits. As forecasted in the below chart, compared with the US, Europe’s major economies will move towards lower deficit and debt levels.
The main reason for this difference is the tax revenue as a percentage of GDP is significantly lower in the US than many other European countries.
Tax-to-GDP ratios, 2021 and 2022p (% of GDP)
Note: Preliminary data for 2022 were not available for Australia and Japan.
With upcoming Presidential elections, there's high uncertainty impacting the US’ fiscal outlook and potential trade tensions. Recent 30-year Treasury auctions have yielded disappointing results, suggesting potential concerns over the sustained interest in long-term bonds, or perhaps highlighting the risks associated with the current market inversion. The main bidder for Treasuries has traditionally been from US domestic investment funds, yet their demand has failed to maintain momentum since last August.
Fed rate cuts but higher yields on longer dated treasuries.
While term premia (TP) has repriced sharply over recent months in line with our forecasts and trade recommendations, we see moderate further upside for several reasons. Firstly, measures of TP remain low relative to history and fundamentals. Secondly, upside inflation risks are higher than pre-Covid and, with inflation still above the Fed’s target, bonds should for some time remain a poor hedge for equities and other risk assets. Thirdly, and perhaps most importantly, domestic and global supply dynamics, which we have highlighted above, are supportive of higher premia, with large US fiscal deficits and ongoing balance sheet runoff or QT in both the US and other advanced economies.
This has led our team to see value in both the shorter end of the curve but also floating rate notes, given our expectations for rate cuts are both further out and so much less than what is presently priced in or expected by the market.
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