As the US 10-year bond market soars further above it’s old “ceiling” rate of 4 per cent it is signalling that bond traders predict the expected US interest rate falls are unlikely to take place and further rises may be ahead.
This is not good news for Australians expecting sizable falls in our interest rates
The chief investment officer at JPMorgan Asset Management, Bob Michele, declared: “The market is pricing in a Fed that will remain restrictive for a long period of time.”
This new scenario comes when, at least on the surface, the Americans are basking in the possibility of a “perfect economy”.
Inflation is falling even though the labour market is strong and company results are coming in above expectations.
The US share market optimists believe that the advance of artificial intelligence will enable productivity to rise in this environment and interest rates to fall.
The American share market swings from fearing the predictions of the bond market to enjoying better corporate outlooks.
I have been searching US commentaries for a clear explanation as to why the long term bond market is taking this stance rather than embracing the concept of a “perfect” or “Goldilocks” economy.
The Wall Street Journal publishes a fascinating explanation which ultimately links rates to defence.
In 2007 US federal debt held by the public was about 22 per cent of gross domestic product (GDP).
In 2011 it was reaching about 76 per cent and is now set to exceed 100 per cent..
Because the Federal Reserve kept interest rates so low — even slashing its overnight borrowing rate to zero in 2020 — the taxpayers’ bill for financing this debt was modest.
But it is rising quickly as the Fed has raised rates to counter inflation.
Net interest is expected to reach $745bn in the 2024 fiscal year which is about three quarters of all discretionary spending, excluding defence.
As rising rates push that financing need higher, the ability of the US government to change the fiscal path without politically disastrous measures like cutting entitlements or by overtly printing money is becoming more limited.
In the absence of spending cuts, the 10-year bond rate will almost certainly remain high.
The US bond rate is seen as a risk-free rate of return so it will crowd out private investment and impact the value of stocks.
Even worse, the US will have restricted room to manoeuvre in responding to the next crisis, whether it involves defence or from the domestic economy.
For example, defending US allies against an attack by China might require not just putting American lives in danger but require a serious trade-off on the home front perhaps combining higher taxes, inflation and benefit cuts. And if China is the adversary then it is a major holder of US bonds.
Accordingly, it becomes important to not gamble that the current “Goldilocks” economy can continue to deliver prosperity while keeping inflation in check.
At the moment, the bond market is expecting the US Federal Reserve to be much tougher and lock in that lower inflation trend via a less prosperous economy.
Both bond and share markets can be wrong but it’s important for Australia to understand some of the deeper motivations that are now moving through the American bond market .
And remember, as I pointed out yesterday, if US rates stay high or rise further then we may not be able to cut our interest rates in the way that is being forecast because it would smash the dollar.
More Coverage
Share tips: stock market experts take a stick to NAB
National Australia Bank and Domino’s Pizza Enterprises feature strongly in new share market buy, hold and sell recommendations.
Don’t spend $85k on two degrees that won’t get you a job
HECS is ‘good debt’, Barefoot Investor tells a mother who paid off her struggling son’s $85,000 bill because he was unable to find a well-paying job or save for a house.