Last November, I submitted my predictions for 2016 in a piece titled “Looks Like Lower and Flatter for 2016.”
By “lower and flatter,” I was referring to longer-term U.S. interest rates and the yield curve, respectively. My thoughts were that a number of factors, most of them outside the United States, would keep inflation well at bay and actually continue to inspire dark thoughts of deflation in Europe and Japan. Additionally, a lower growth recalibration for China and emerging market economies due to a strong U.S. Dollar (USD) would drive rates lower. This summer, there was serious speculation that the Bank of Japan (BOJ) would actually resort to “helicopter money” to try and ignite inflation, and the European Central Bank (ECB) seemed on a course to deepen their drive for negative interest rates. So for nine months I was right, actually 10, if you count December 2015! However, the election of Donald Trump on November 8, 2016 destroyed the call. Literally overnight, markets began to price in a very high probability of what central banks have been trying to do, with little or no success since 2010, global economic reflation. And with that, my 2016 call was destroyed! Yields skyrocketed and while the U.S. Treasury yield curve actually flattened, it flattened because a more hawkish Federal Reserve pushed short- to medium-term rates up sharper than longer term rates, not something I called for.
Thinking of this reminds me of the 1974 film, “The Gambler,” starring James Caan. Caan plays degenerate gambler Axel Freed. In one scene, Axel has just lost huge bets on a game. Axel’s bookie comes to his house in the middle of the night to collect. In the era before cable TV and ESPN, Axel went to bed thinking he won. He didn’t. Axel, stunned, says to the bookie, “But Harvard was way up.” Jimmy the bookie cuts Axel off and says, “They don’t give out no prize at halftime Axel.” And so it is with my 2016 call. No prize for being right for three quarters.
So what is the call for 2017?
Is the great global reflation trade really upon us? Are the days of central bank negative policy rates and ever flattening yield curves over, or has the last three months just been a blip on the post-Great Recession low growth and zero inflation era? There are cogent arguments for both views. With regard to reflation, the election of Donald Trump, along with his policy proposals of massive fiscal stimulus, have answered the cry that we have been hearing from the markets for years, “When will governments step in with fiscal policy to take the baton from central bank monetary policy and carry the weight?”
The psychological impact of the promise of growth-producing stimulus and sweeping business de-regulation has been extremely strong. Some famous investors refer to this as the “release of animal spirits.” This has been reflected in the 5% increase in the S&P 500 and the sharp tightening of corporate credit spreads since Election Day. With regard to inflation, the spike in Treasury yields reflects a far more positive view than existed before Election Day that the Federal Reserve will reach its 2% core inflation target at a quicker pace. Additionally, in a longer term view, if President Elect Trump follows through on his promises to renegotiate trade agreements, impose sharp tariffs on imported goods, coerce U.S. companies into reversing the exporting of jobs overseas, and strongly enforce immigration laws (including the expulsion of illegal aliens), then it is very conceivable that the cost of goods and services can rise considerably and work to break the low inflation mindset of the American economy.
Therefore, if you believe the new Presidential Administration and Congress can enact their agenda (assuming that the President and Congress are on the same page), the psychological impact of inflation can take hold, which as long as it does not get out of control and become corrosive, can promote faster economic growth and break the cycle of abnormally low interest rates. Under this scenario, there’s no reason the 10-year Treasury can’t get to 3% in 2017.
However, I believe the arguments against the reflation scenario are stronger. A dominant theme that I first wrote about soon after the election is a looming battle between the Federal Reserve and the Executive Branch.
I believe that the reflation scenario relies on a relatively passive Federal Reserve. However, Fed Chairwoman, Janet Yellen, has stated on multiple occasions that a large fiscal stimulus package in a time of near full employment will cause the Fed to recalibrate their growth and inflation estimates. One would assume that means the Fed tightening monetary policy at a quicker pace. Additionally, before the election in October, Ms. Yellen stated in a speech that she found the idea of letting the economy “run hot” for a while after full employment is reached as something fairly palatable. After the election, at the December FOMC press conference, Ms. Yellen completely backed away from her “run hot” comments stating it was a “research discussion” and not an “experiment in real time.” I think the Chairwoman’s reversal was done to open the door to a potential hawkish response to a fiscal stimulus package that she thinks could create corrosive inflation.
The global markets, most notably in the currency markets, have already factored in a more hawkish Federal Reserve. The Bloomberg USD Index (DXY) appreciated nearly 6% since Election Day, reaching levels not seen in 14 years. The stronger USD is already tightening monetary policies of emerging market economies as well as China causing economic disruption and potentially destabilizing capital flight. The capital flight from China is approaching—and may be exceeding—the levels reached last December. Yesterday, China essentially devalued their currency by diluting the amount of the USD (and currencies pegged to the USD, like the Hong Kong Dollar) in the basket of currencies it uses to set the on-shore Yuan exchange rate from 33% to 30%. The currencies that replaced the USD were emerging market currencies that react similar to the Yuan in the face of USD strength. The weakening of the on-shore Yuan will exacerbate an already dangerous capital flight situation in China, which in turn tightens credit above and beyond where the People’s Bank of China (PBOC) wants it. China will be a strong counterweight to the reflation argument in 2017.
There are other major issues in the global economy that can also counter the reflation, higher long term rate scenario. Most notably, the European banking system where the weakness of Italian banks is ready, in my opinion, to start a battle between the ECB (and by extension, Germany) and the Italian government, which is manned by a caretaker prime minister until new elections are called in 2017. The specter of Germans dictating to Italians the rules by which they can bail out their failing banks can be a large flashpoint that brings anti-European Union (EU) leaders to power in Italy. The United Kingdom voting to leave the EU in June was and is a very destabilizing event that is still unfolding. The thought of Italy contemplating an exit from the EU would break the union. The potential of this event is another strong counterweight to reflation.
I believe the combination of the Federal Reserve ready to counter a fiscal stimulus package from the Administration and Congress with tighter policy, the potential for economic and political unrest in Europe, and undesired tighter financial conditions in China and Emerging Markets will force 10-year Treasury yields back to 2% in the first half of 2017 and five-year Treasury yields back inside of 1.60%. I predict that the Fed will force the Trump Administration to step away from meaningful fiscal stimulus and thus only raise rates twice in the coming year. However, perhaps the most important thing to keep in mind for 2017 is it will be a year of tremendous volatility, one that makes 2016 look like a walk in the park.
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