More clients are beginning to worry about upside risks to inflation, and most
clients agree that if the consensus is right that GDP growth over the coming quarters will be around 3%,
mainly driven by strong capex growth, then we will also continue to see more signs of an overheating
labor market and continued labor shortages across sectors including transportation, retail, homebuilding,
and health care. With core PCE inflation today already at the Fed’s 2.0% target this projection of
continued above-trend GDP growth is pointing to more upside risks to inflation than the end-of-year 2.1%
expected by the consensus and the Fed. Some clients push back and say that the consensus capex forecast
is too optimistic and companies will end up doing buybacks instead of capex. But the Q1 GDP data showed a
very strong capex number suggesting that the corporate tax cut will not only be spent on buybacks but
also on business fixed investment, in particular in tech. The bottom line is that there is a significant
risk that core PCE inflation in 2018H2 will overshoot 2%, which would push the term premium higher and
steepen the yield curve. The argument for a move higher in the term premium is strengthened by the fading
of the corporate pension bid for the long end, which will go away in Q4 after the September deadline for
contributing to corporate pension plans at the old 35% corporate tax rate.
The total supply of US Treasuries that has to be absorbed by the market
(i.e. Treasury net issuance plus Fed running down their balance sheet) will increase from $700bn in 2017
to $1.3trn in 2019, and the key question continues to be: Who will buy all these Treasuries and at what
interest rate? Many clients want to discuss the impact the increase in T-bill issuance in 2018H1 had on
Libor-OIS and CP and short duration IG. With the US Treasury’s stated goal of keeping the average
maturity of government debt constant at around 5.5 years the Treasury will have to issue more paper in
the long end in 2018H2, which raises the risk that long-duration credit spreads will widen out in H2,
similar to what we saw for Libor-OIS, as issuing more risk-free assets begins to compete for dollars with
more risky assets, especially IG. The bottom line is that in 2018H2 increased Treasury supply will push
long rates higher and credit spreads wider. Wider IG credit spreads will also be the result of ECB
exiting QE and rising hedging costs for foreigners buying US fixed income, mainly driven by the Fed
raising short rates.
US overheating and the explosion in
Treasury supply all point to higher rates across the curve. A full-blown trade war, however, would be a
drag on rates. But most clients agree that the trade war is so far not having any meaningful impact on
the US economic outlook. Specifically, tariffs on $34bn of imports is very limited when taking into
account that US total imports are around $2.5trn. If we begin to see tariffs on autos or auto parts then
it will be much more serious because US auto manufacturers, suppliers, and dealers account for around 7%
of total employment in the US economy. The bottom line is that the negative impact of the ongoing trade
war is small but if the trade war moves to cars and car parts then it would begin to exert a meaningful
drag on GDP growth and hence also on equities, Fed expectations, and long rates.
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