DPAM Blog

STATE OF AFFAIRS

• • Not surprisingly, the reflation momentum was alive and kicking over the past week in markets, as expectations of a floor vote by the end of February for a Biden stamped US fiscal package became consensus. Time to go big was uttered by Janet Yellen and endorsed by the IMF. The bill is based on USD 1.9 trillion of fiscal spending directed at food stamps, unemployment benefits, USD 1400 per person payments showing an individual income of less than USD 75k and an acceleration of vaccine deployment and testing capacity. In parallel, negotiations kicked off to discuss a sweeping infrastructure bill the moment the virus aid is approved. The infrastructure bill will carry a multi trillion tag. We want to stress that, for financial markets, the canary in the coalmine might be the infrastructure bill instead of the current disaster relief spending. The canary in the coalmine, not because it would lift, let’s hope, potential growth, but because this bill would require an increase in taxation for corporates and high earners. Both groups have seen their valuations and net worth increase substantially, increasing the gap with middle and lower classes. One could say that the bill under discussion, finishing around USD 1.4 to USD 1.5 trillion given reconciliation impact, is a one-off income subsidy, directed at left behind lower and middle classes. The relief package might positively impact 2021 real GDP but peter out completely by 2022. Indeed, one should refrain from extrapolating the package as having a multi-year positive impact on US GDP. The fiscal multiplier will be closer to 0 than to 1, as the propensity for households to spend the paycheques will be modest. On the other hand, the propensity to reduce household indebtedness might be high. If that would be the case, the pent-up demand narrative might be very short-lived

• • Last Thursday, February 11, the US Congressional Budget Office released their Budget and Economic outlook: 2021 to 2031. With real growth of 3.7% over 2021, the US economy would return to its pre-pandemic level over the summer. Real growth would average 2.6% over 2021 till 2025, thereby closing the output gap by early 2025. One cannot underestimate the importance of the above, as markets should distinguish between growth recovery and the growth path required to close the output gap or slack, underutilisation of capacity, in the economy. The 2021 budget deficit forecast sits at USD 2.3 trillion, or 10.3% of GDP. It dips to -3.6% over 2024 to still run at -5.7% in 2031. For the people in doubt, the above fiscal largesse will push the US central bank in maintaining its asset purchase intensity intact for longer. Calling for policy normalisation through early 2022, QE tapering is premature. The trajectory for real GDP that the CBO depicts concurs with the view reflected in previous editions. After a 3.7% recovery expected over 2021, real GDP drops towards 2.2% and 2.3% over 2022 and 2023 but slides towards 1.6% over 2026-2031. That is 0.2% below the 1.8% potential US growth rate reached by FED analysts. I believe it is once more premature to expect higher long-term potential growth conditions that would explain higher long-term rates.

• • The infrastructure proposal will include expansions of rural broadband, road and bridge repairs, half a million charging stations for electric cars amongst other projects creating millions of jobs. Whether the Biden-Harris administration will opt for immature deficit financing versus responsible and redistributive taxation is a crucial choice and decision. For inflated risk-free and risk assets, most choices are suboptimal. We have witnessed and welcomed some decompression in core rate markets. Spread-based financial instruments show resilience but might crumble if core yield curves steepen further. On this latter question of steepening potential for the US yield curve, I dare to make a forecast. If the future will prove me wrong or right is not important. The purpose is merely to keep vigilance intact.

• • A majority of market strategists predict that the US yield curve steepens further. Let’s have a look at the 2-year versus 30-year interest rate differential. This measure closed at 1.90% last Friday. Over the past 44 years, the average 2y30y steepness stands at 128.7bp. For simplicity, we will use 1.30% or 130bp. Interestingly, since the global financial crisis (GFC) of 2008-2009, this metric has never touched the zero bound. Indeed, the zero- interest rate policy rolled out by the FED has made yield curve inversion as good as impossible. The low over the post GFC-cycle was around 40bp, observed over September 2018 and September 2019. Both were moments where markets estimated that the FED tightening cycle was coming to an end. This 40bp low was about 40bp away from the 1 standard deviation (SD) level that sits at the 0.00% level over the observation period. The 1 SD on the upside prints at 2.55%. Applying the ‘undershoot’ of 40bp from the 1SD on 2y30y curve flatness to the steepness potential we arrive at a target steepness level of 215bp or 2.15% i.e. 2.55% minus 0.40%. With current 2y Treasury rates anchored around 10bp we arrive at 2.25% on the US 30-year long bond. The 30-year long bond closed at 2.00%, leaving us with a mere 25bp from target on this back-of-the-envelope scenario. 2-year rates might indeed test the 0.00% level, making the current 2.00% even more interesting. I repeat, a disclaimer is in order, as bond investing is not at all about timing. The purpose of the above exercise is merely to provide some guidance in an era where markets tend to re-price fast and furiously on the upside as well as on the downside.