Investment Newsletter – October 2023
Interest rates on US debt are on the rise primarily due to economic growth and increased debt issuance. This is evident in the sustained significance of real interest rates and term premiums as major contributing factors. In contrast, there haven’t been significant changes in inflation expectations and the projected trajectory of interest rate hikes. Whether it’s robust economic growth or substantial debt issuance, these trends are a direct consequence of fiscal generosity rather than currency-related factors. The government’s expansion of credit and its “underwriting” of private sector risks have also heightened pressure on the fiscal balance, leading to increased repayment obligations and elevated interest rates.
Several factors are poised to curtail the potential for fiscal stimulus in 2024. These factors encompass the limitations imposed by the debt ceiling, the dynamics of bipartisan politics during an election year, and the escalating costs associated with interest payments. Consequently, the government’s inclination to rely on credit-driven leniency may encounter heightened constraints. There are risks associated with this assessment, such as the potential for 1) another event resembling the financial crisis of 2008 necessitating continued fiscal easing, and 2) potential disruptions in the geopolitical landscape.
The deceleration in fiscal activity signifies a tightening of the credit cycle, which could result in a general decline in long-term treasury bond yields. Nevertheless, this decline is expected to be gradual and may necessitate specific catalysts and turning points, such as sudden increases in interest rates, unforeseen risks, or weakening key economic indicators.
In latest biannual Financial Stability Report, the US central bank has raised concerns about the potential for global market disruptions if conflicts in the Middle East and Ukraine intensify or if other issues emerge. They also noted that Treasury market liquidity remains low compared to historical levels, indicating caution among market participants, especially riskier borrowers are beginning to face more significant financial challenges.
The Bank of Japan continued to pursue a contradictory monetary policy. On one hand, the bank aims to achieve a sustainable increase in the longer-term underlying inflation rate, which had been hovering around 0% for approximately two decades prior to the pandemic, with the target set at 2%. On the other hand, the bank is now also working to counteract the post-pandemic inflation surge, which has propelled core Consumer Price Index (CPI) to its highest level since the early 1980s. What’s noteworthy is that, instead of concentrating solely on addressing the immediate issue, as most other central banks in developed economies do, the Bank of Japan is endeavouring to shape its policy to simultaneously address both its short-term goal of reducing inflation and its long-term goal of increasing inflation.
The IMF believes China’s economy will benefit from a shift away from property sector dependency. Allocating resources to more productive sectors such as electric-vehicle production, technological innovation, and environmental protection will boost the economy. However, the IMF warns of a growth slowdown to 3.5% next year, attributing it to weak productivity growth. It emphasizes the need for China to adopt pro-market structural reforms to boost growth.
