The US election verdict is conventionally thought of as implying even higher fiscal deficit via tax cuts, higher tariffs leading to higher inflation and lower global growth, lower immigration again with impact on growth and inflation, and more deregulation potentially offsetting drag on US growth from these other mentioned sources. The market implication of this is thought to be potentially steeper yield curves in the US reflecting both a rise in inflation expectation as well as higher bond supply. Since bottoming out around 3.6% mid-September, the US 10 year bond yield has risen a hefty 75 bps partly reflecting these expectations. However, as the chart below shows, there is also a large element here of US data beginning to consistently surprise positively which was already weighing on the quantum of previously expected rate cuts even before the election related pricing started to take hold.
The fact remains still that there is a large element of uncertainty with respect to the eventual shape of policy implementation, the timelines associated, as well as the net impact that unfolds eventually. It is also possible that market is only focused on the most obvious aspects of what it thinks are likely to be the new administration’s stance, without looking for offsets elsewhere. This is understandable as only the most defining changes would be talked about on the campaign trail while once in office a total plausible plan for implementation will need to be thought through. As an example, as per some forecasts while the central tendency is for deficit to rise by approx. US 7.5 trillion over the next 10 year or so, the range of outcomes are +- USD 5 trillion of that number. Also a significant portion of the projected fiscal expansion is on account of income tax cuts that were supposed to expire in 2025 but are now expected to be rolled forward. However, in most projections there is no serious element of expenditure management that is envisaged even as there is talk of a reasonably high profile appointee for this task. Also, it seems somewhat strange that any working administration will be content with higher inflation and rates on the population without actively looking for ways to change this. As an example, US 30 year mortgage rates are in the vicinity of 7% which has caused the housing market to freeze over. If the talk of town currently fructifies, then these rates are supposed to go up even further.
Given the uncertainties, we find less value at the current juncture in being overly deterministic. Rather we focus below on understanding context, that is how this period is different from the previous one of the same US president. These also help determine offsets that may be available which may dilute the market implications currently thought of. Note our analysis is largely versus the period 2017 – 19 since this tracks clearly variable changes with implementation of new policies but stops short of the pandemic period which brought about a complete change in direction. Since market variables like bond yields move on expectations as well, we have included data from the time of election results in Nov 2016.
Then And Now
We summarize some of the takeaways below:
1. The US Fed hiked policy rates 200 bps then, taking Fed funds rate to 2.25 – 2.5%. The discussion now is on the pace of cuts with the Fed (and markets) wanting to discover what the new long term neutral on Fed funds rate is likely to be. Even with 75 bps cuts so far in this cycle, Fed funds rate currently is at 4.5 – 4.75%.
2. The US 10 year real yield was a very low 15 bps at the start of this period and rose to 1.15% towards the end of it. It currently stands at 2% (more on this below).
3. US fiscal deficit was 3.2% in Sept 2016 thereby providing ample room to expand. There was a 140 bps expansion over the next 3 years. In contrast it is already at 6.4% and slated to expand further as per current projections (more on this below).
4. ECB kept rates on hold at -40 bps during the period of Fed hikes. While it has cut rates by 75 bps in this cycle so far, its policy rate is still at 3.25%. Importantly, this is despite Eurozone growth being much weaker now (0.7%) than it was then (2.2%). While ECB only has an inflation target, weaker growth eventually feeds into weaker inflation. Indeed, the discussion already is that ECB may be falling behind the curve on cuts and market expects another 150 bps odd cuts in this cycle. If the new US tariff proposals go through, growth prospects in the Eurozone may deteriorate even further.
5. China growth is much weaker now (4.9%) than then (6.8%) and escalating tariff will hurt it more. Monetary policy relevance for incremental growth is largely exhausted and the focus has now turned to fiscal expansion. Export is a key engine for growth given that domestic demand is weak. Higher tariffs imposed by US may incentivize China to step up exporting out its excess capacity to non US nations. This may incrementally disincentivize local investment and production in such geographies.
6. Currency trends then may seem very counterintuitive from what is expected now (both CNY and EUR appreciated vs USD over 2017 and then depreciated with little change over the full period as described in the table above). However, the context then needs to be appreciated. EUR was coming off the Greece crisis in mid- 2015 and CNY from the voluntary devaluation of Aug 2015 and subsequent further depreciation. Also starting growth conditions for both were much stronger then than what is the case now.
Offsets
The discussion above leads us to assess some of the potential offsets to the central narrative of higher US fiscal deficit, higher inflation, and higher longer term rates.
1. The Interest Rate Insensitivity Assumption: We have mentioned above the extent of variations in budget forecasts, the inability currently to quantify expenditure savings, and the current assumed insensitivity to higher rates in the US economy. While the higher fiscal deficit has played a large part initially, the incremental fiscal impulse hasn’t been as supportive. A lot of the continued resilience of US growth is chalked up to: a burst in productivity underscored by rise in tech investments, labor pool expansion basis increased immigration, and longer term private sector liabilities that has blunted the impact of higher rates. While the first of these factors may be enduring, the rest aren’t. In particular the damage to the housing market and to leveraged consumption is already apparent in the US. With passage of time, as more liabilities come up for refinancing, the effect will likely become more visible. It is quite unlikely in our view that the economy, the administration, and the Fed remain immune to the rise and rise in long term interest rates. Indeed, the question has already surfaced in the last press conference of the Fed Chair, though for now he didn’t seem particularly perturbed.
2. The Fiscal Dominance Framework: It is stating the obvious that US macro policy is now dominated by its fiscal stance. So far it has manifested as more aggressive rate hikes and higher real yields reflecting the fiscal risks, as well as a stronger dollar. However, the current trifecta of rising deficit, higher real yields, and stronger dollar is fundamentally unsustainable insofar that it will significantly curb financial flexibility for the treasury in the form of significantly rising real debt servicing cost. It is to be noted that the longer rates stay where they are, the closer the average borrowing cost starts moving towards the incremental cost, thereby further jeopardising future budget flexibility. Thus, if the rising budget deficit is a given then one or both of the other two variables must yield. This will put a cap on how much higher nominal yields and / or the dollar go on a sustainable basis. One has to note here that what is generally tracked as the dollar index is heavily skewed towards the Euro. Given rising economic uncertainties in the Eurozone area, it is quite possible that the Euro keeps depreciating versus the dollar, thereby supporting the dollar index, even as the broad based dollar strength gets arrested basis the factors analysed here.
3. The Tariff Implications: US growth has been an anchor for global growth as well over the past few years, given that it is the largest economy by some margin and growing at a pace higher than what is traditionally deemed as long term potential growth. This has created some benefits / tailwinds to growth elsewhere as well. However, as per many economists, further tariff escalations will net subtract from global growth (production and distribution inefficiencies, impact to business sentiment, etc) and redistribute it on the margin. In geographies like Eurozone, the economic outlook may turn more grim and with the current space available with monetary policy, aggressive policy easing may very well get called for. In a global context, such developments may partially offset incremental hawkishness from the Fed even as the US central bank itself may eventually have to accommodate the fiscal dominance framework as described above.
4. Relative Yields: Extending from above, the envisaged pressure on US yields may also manifest partly as rising yield spread between US and (say) Germany. This is already happening (50 bps rise in relative spread between US and Germany since mid September) but may have a lot more room to run. This may put a cap on how much higher US yields can go on a sustainable basis.
Thus far we have established how the context is much different between then and now and how these may be throwing up some offsets to the central market narrative associated with the new Presidency. We turn next to a brief discussion closer home.
India Assessment
It is well recognised that India growth data turned somewhat bumpy for the September quarter, as borne out both in economic and company data as well as in general commentary. RBI’s inclination seems to be that this is largely owing to excess rains and inauspicious consumption period. Indeed, we have seen some rebound in concurrent economic data from October. A pick up in government spending and good harvest are positives. However, there are undeniable risks as well that argue for some cyclical slowdown going ahead. Leveraged consumption is already slowing with tighter lending standards and more caution with respect to growing certain segments of consumer loans. Private capex outside of the real estate cycle has been patchy so far and may face an additional headwind of uncertainty from the likelihood of an escalation in global tariff wars. On the other hand, the latest CPI reading has shocked at 6.2%. But peel vegetables out (and lately edible oils to some extent) and the rest of the basket continues to grow below 4%. We still think that the growth-inflation mix will likely allow the RBI to commence easing from February.
From an external risk perspective, India continues to be seen as low impact: both market standpoint from rising dollar and US yields, as well as growth standpoint from direct tariff war implications. Indeed, this has also been borne out in the most recent period since mid September when rupee has been one of the most stable currencies versus the dollar. On the point of currency, there is one channel that may present a point of concern: if there is aggressive CNY depreciation in response to tariffs, then will rupee have to follow suit to maintain bilateral competitiveness. If so, then will this sour the relatively new found FPI sentiment with respect to India bonds? While definitely a risk, we don’t think this is likely in a meaningful way for the following reason: One, an important learning from the CNY devaluation of 2015 was that this can speedily trigger a capital outflow problem which may get hard to arrest. Thus it is likely that this tool is used more judiciously. What is of some comfort also is that the threat of new tariffs is happening now when there is some semblance of stability in the real estate market and fiscal policy has kicked into action, rather than a year or two back when it may have hurt much more. Two, while one understands that RBI looks at a CNY/INR band, this band appears to be wide enough to allow some flexibility. As an example, the period since Jul 24 has seen wide fluctuations in the CNY/INR exchange rate. Thus, we don’t expect the relatively stable perception on rupee and rupee bonds to be meaningfully change even as FPIs may very well be in a wait and watch mode in the near term. What is also very helpful is that India bond demand – supply balance remains quite favorable in the near term basis local demand alone. This is even more so if one considers potential additional demand emanating from some form of the proposed liquidity coverage ratio guidelines for banks.
Conclusion
It is a given that market uncertainty has risen post the US elections. The intent here has been to show that this cuts both ways, including with respect to the central narrative on market implication associated with the election outcome. This is especially true given the ‘then vs now’ and the associated offsets analysed above. Meanwhile, India remains a sound story with a favorable bond demand-supply environment, thereby likely offering relatively low fluctuation risk. Waiting for absence of volatility to invest may be never-ending, especially as a lot of the actual policy implementation of the new administration (especially fiscal policy) may be quarters away, and may itself be subject to iterations basis perceived impact on basic variables like inflation (which matters a lot to people, especially now, and hence to administrations). Meanwhile, there are other variables that are changing that are decidedly in favor of bonds especially in relatively low impact markets like India.
Source: RBI and Bandhan internal research
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