US on dangerous ground

The question now on everyone’s mind is whether the 2% long-term inflation rate target is still valid and what if that rate is higher. — Bloomberg

FOLLOWING the cut in the long-term foreign-currency issuer default rating to AA+ from AAA by Fitch Ratings on Aug 1, 2023, the US fixed-income yield curve has steepened considerably with notable movement on the long-end.

According to Fitch Ratings, the downgrade of the US credit rating was driven by the expected fiscal deterioration over the next three years and a high and growing general government debt burden.

Despite the 525-basis-point (bps) increase in the Federal Funds Rate (FFR), Fitch Ratings expects another 25-bps hike, taking the benchmark US rate to 5.50% to 5.75% by next month.

In addition, a cut in the FFR is not envisaged until March 2024, mainly due to the stickiness of the core personal consumption expenditures (PCE), which increased by 4.1% year-on-year (y-o-y) in June 2023.

The recently released inflation prints also suggest that inflation is not being tamed fast enough, as the headline inflation for July 2023 rose by 3.2% y-o-y – the first uptick in more than a year, while core inflation increased by 4.7% y-o-y.

Meanwhile, the market too is pricing in almost the same scenario as Fitch has envisaged with one more rate hike next month, while a rate cut is only expected to commence in March 2024.

Thereafter, a further four rate cuts of 25-bps each are expected, which will take the FFR to 4% to 4.25% by the end of next year.

Unprecedented move

Since the first rate hike that was initiated last year, investors’ focus has largely been towards the shorter end of the US treasury yield curve.

The long end of the curve, meanwhile, has seen relatively less movement as investors foresee that the Federal Reserve (Fed) would be able to contain inflationary pressure and the long-term inflation expectation of 2% will be met, in time to come.

In fact, the 30-year US Treasuries have only gained some 320 bps from the low of 1.17%, much less than the FFR, which has been raised by as much as 525 bps since the first rate hike in March 2022.

The question now on everyone’s mind is whether the 2% long-term inflation rate target is still valid and what if that rate is higher.

What are the implications for long bonds if these expectations are at 2.5% or even 3%?

According to hedge fund billionaire Bill Ackman, if the long-term inflation rate is at 3% and not 2%, the long bond should be at 5.5% and not where it is today.

Compounding Fitch’s rating action, the US Treasury’s move to increase the size of longer-term debt papers too caused investors to demand higher rates for the long bond.

True enough, with the downgrade by Fitch, although not echoed by other rating agencies like Standard and Poor’s (S&P) and Moody’s Investors Services, the 30-year US Treasury moved by as much as 31 bps before easing to 4.24%.

The 10-year gained 23 bps to 4.19% before turning lower and was last seen at 4.12%.

At the shorter-end, the two-year US Treasury fell by two bps while the three-month US Treasury was last seen at 5.45%, up by two bps this month.

The steeper movement of the long-end brings to question whether the market is re-pricing inflation risk, or is there a more profound development that could have longer-term consequences for the capital markets.

Steep curve

Since the move to raise the FFR, the US yield curve has been flattening to the extent we had even observed inversion, almost entirely across the board, mainly taking the cue from the higher FFR as the short-end of the curve is more sensitive to rate movement than the longer end.

The 10-year minus the two-year US treasury saw inversion of as much as 108 bps and was last seen at 73 bps, contributing to the steepening of the yield curve.

The sharp movement on the longer end of the US treasuries could also mean that investors are repricing the risk of US debt papers on the back of an increase in debt supplies, which is counter-balance but by a lesser extent of the Fed’s move to reduce the size of its balance sheet. Investors are in essence demanding higher returns for the longer-end papers.

Not only the US federal government debt is in unchartered waters – a statement that is repeatedly said as the US debt level has only been going one way, north – but so are household debts, which were last observed at US$17.1 trillion (RM78.3 trillion).

According to The Kobeissi Letter, an industry-leading market commentary on the global capital market, mortgages hit US$12 trillion (RM54.9 trillion) in total, while auto loans and student loans are at US$1.6 trillion (RM7.3 trillion).

Unprecedented was the move in credit card debts, which has hit US$1 trillion (RM4.6 trillion) as more individuals roll over debts or took on more credit to make ends meet.

The US federal government too is up against the ever-increasing cost of servicing its debts with the latest July year-to-date cost of US$726bil (RM3.3 trillion).

This will likely surpass the US$1 trillion (RM4.6 trillion) mark this year.

If the market is right in believing that there is some element of repricing of inflation risk going forward, the implications on the global economy, capital markets and debt servicing ability of all borrowers will be severely tested.

This could even mean that the shift to a higher inflation rate is here to stay – a dangerous ground for all.

Pankaj C. Kumar is a long-time investment analyst. The views expressed here are the writer’s own.