Rate cut hopes dashed

OVER the past three weeks, the US fixed income market has seen the key benchmark 10-year US treasury rates rise to as high as 4.79%, an increase of 25 basis points (bps) since its close at 4.54% at the end of last year and was last seen at the 4.61% level.

The 10-year reached its highest point in eight months on concerns of sustained inflationary pressure, which has also led the US dollar to extend its 7% gain in 2024 with a year-to-date gain of 0.4%.

Interestingly, since the US Federal Reserve (Fed) first cut the Fed Fund Rate (FFR) by a jumbo move of 50bps in September last year, followed by two rate cuts of 25bps each in November and December, the 10-year US treasury has moved in the opposite direction.

While the US FFR has been cut by 100bps, the 10-year US treasury rose by more than 100bps from 3.71%, which was the level on the day the Fed lowered the FFR by 50bps back in September last year.

This phenomenon can only be explained by investors placing larger bets that the US FFR would remain relatively high, amid fear of sticky inflation prints and economic measures or tariffs that President-elect Trump may impose when he takes office next week.

Sticky inflation

The major gauges that the US Fed looks at are the US personal consumption expenditure (PCE) and the core PCE. In the latest November 2024 reading, although the core PCE stood steady, rising by 2.8% year-on-year (y-o-y), the headline PCE indicator rose by 2.4% y-o-y.

This was quicker than the preceding two months when the headline PCE increased by 2.1% in September and 2.3% the following month. Other indicators too showed inflation remains sticky with the core consumer price index (CPI) higher by 3.2% in December, coming in a tad lower than the consensus forecast of a 3.3% rise, while the headline CPI rose by 2.9% against a 2.7% increase in the preceding month.

Tight labour market

The US labour market remains resilient despite the extended period of elevated interest rates, proving a point that the labour market seems disconnected from inflationary pressure and how high rates have been, despite the Fed’s move to cut rates.

The December 2024 non-farm payrolls, which jumped to more than 256,000 and well above forecast, was a key barometer as to how good the US job market has been.

Even the unemployment rate fell to just 4.1% as some 2.23 million jobs were created in total in 2024. Although lower than the three million that was registered in 2023, non-farm payrolls for last year averaged more than 164,000 per month, which is likely enough for the Fed to turn hawkish again.

Rate cuts?

Following the jobs report last week, the market has begun to re-price expectations on rate cuts with consensus kicking the can down the road with a June 2025 rate cut of just 25bps. With the reduced probability but now with an earlier expected rate cut against the previous forecast of a September rate cut move, the dollar index, which crossed the 110 mark just a few days ago, has pulled back marginally.

Nevertheless, the dollar could resume its uptrend and re-challenge the 110 level and perhaps even breach the 113 mark that was last seen in October 2022.

Risk-off for now

Economic conditions will get tougher should the dollar remain strong and continue its upward climb.

As currency plays a crucial role in cross-border investments and trade, the yield spread that the US treasuries are giving investors is pulling other asset classes lower.

China, the world’s second-largest economy, has its domestic economic issues as the government is struggling to lift consumer sentiment, made worse by a deflationary environment.

The latest CPI data show that Chinese inflationary pressure is more or less absent, while the producer price index shows that factory prices are even weaker as they fell by another 2.2% last year, after falling by 3% in 2023.

China’s 10-year sovereign paper too has dropped considerably to just 1.65%, almost halved from the level seen about four years ago.

Inflation or debt fear?

One of the toughest debates out there is the real cause of rate hikes and the source of the nervousness among investors.

Most investors are keeping an eye on inflation prints, jobs data, other economic hints, and even the potential spike in inflation due to President-elect Donald Trump’s move that may rattle trade and inflation expectations.

However, there is also another school of thought as to why yields are spiking and this is caused by fear of debt and deficits, especially out of the United States. When Donald Trump takes office next week, and going by the book as to what he has promised, the US government is likely to carry out populist measures, which include a cut in federal taxes.

To reduce leakages and the loss of revenue from tax cuts, Trump has established the Department of Government Efficiency led by Elon Musk, who will identify ways to cut expenditures.

What is clear as far as the United States is concerned is the sticky nature of its public expenditure, which does not have much room for cuts as some 80% of government spending is related to social security, Medicare, defence spending and debt servicing.

Hence, while the market is fixated on economic data points and in particular aggregate prices and the labour market, there is another wheel that is spinning rather fast in the form of accelerated debt increase under Trump, which if left unchecked, will result in yields remaining rather high to compensate for the higher risk and the US government’s ability to service its debts.

It seems market volatility has hit early on in 2025 with most markets fearing that the spike in yields will cause the great rotation as stocks become pricier under a higher interest rate environment causing risk premiums to rise while bond yields become more attractive to investors locking in for the longer term.

With rate cut hopes dashed, the dollar has regained its supreme position and is poised to rise further.

Investors are willing to set aside the debt and deficit issues of the US government simply on the basis that risk-free money in the form of US treasuries is good enough for now.