The Cambridge Weekly –22nd January 2024

The Cambridge Weekly – 22nd January 2024

Data versus Davos

Last week, global capital markets resumed their volatile path of last year, as the positive sentiment, driven by expectations of an imminent and significant onset of rate cuts, began to wane somewhat. The combination of a distinct slowing in the downward trajectory of inflation, paired with increasing confirmation that economic conditions are more on the up than down (at least in the US), have made it even less probable that rates will be cut soon and fast. As a result, some investors have begun to face up to the very distinct possibility that bond yields may have undershot during the end of 2023 euphoria, and that rates may only begin to be cut later and then more slowly. In other words ‘lower, slower’ seems to be replacing last October’s ‘higher for longer’ narrative.

Understanding national debt and deficits’ sustainability limits

Government bond yields are crucial to any investment outlook. The last few months of 2023 saw an astounding rally in bond prices – the inverse of yields – once capital markets started predicting interest rate cuts. That lowered the so called ‘risk-free’ rate of return and pushed up stocks virtually everywhere. The first few weeks of 2024 have seen a pullback in bonds, and hence equities have had a bumpier ride.

As the risk-free rate, yields are generally determined (in secondary markets at least) by the expected outlook for growth, inflation and interest rates. They are risk-free in the sense that governments can always – at least in theory – pay back the sums borrowed, if only because they can print more money. But rates fluctuate dramatically based on multiple risk factors and, in reality, governments have to act like responsible borrowers if they want funding to stay available.

US deficit position and challenge

Deficit increases are more apparent in the US than anywhere else. This is partly just because the US is the largest economy in the world, and the US Treasury is the biggest national borrower – so people notice when it asks for more. But the trend toward fiscal expansion over the last decade is undeniable, and exceeds the growth in the US economy. This became very apparent during Donald Trump’s presidency, when dramatic tax cuts drained the Treasury’s coffers.

The Republican Party has a reputation for favouring fiscal conservatism – most famously with the ‘Tea Party’ movement that opposed basically all spending during the Obama administration. Trump captured the hearts of many former Tea Partygoers, but simultaneously abandoned any pretence toward deficit reduction. Coming late in America’s then growth cycle, Trump’s tax cuts meant the US entered the pandemic with already stretched debt metrics.