The successful passage of US tax reform could boost the economy by 0.5% in the year ahead and force additional tightening measures from the Fed.
Government bond yields rose modestly during the past week, with data continuing to underline the robust state of health of the global economy. Meanwhile, a modest rise in the Core PCE inflation measure would appear to vindicate Federal Reserve (Fed) expectations that inflation may gradually return to target during the course of 2018, allowing interest rates to continue to rise as they have been suggesting. In our view, cyclical pressure pushing inflation a little higher will now start to outweigh structural trends pulling inflation lower and our meetings with the management of US corporations in a number of sectors have underscored this, with a notable upturn in employee compensation, capex intentions and M&A interest, all being registered in the past month or two. We continue to believe that financial markets are far too complacent on the possibility that inflation may rise and consequently remain stubbornly sanguine with respect to the Fed and higher interest rates. This has seen a substantial flattening of the yield curve and although the trend towards flattening is something that may persist through 2018, for now, we see scope for the 10-year point on the curve to underperform, should the 2017 trading range be broken to the upside, leading volatility to rise.
Yields in the eurozone continue to be supported by low rates and a dovish European Central Bank (ECB). Comments from board members such as Klaas Knot, arguing for an end to bond purchases in September next year may become mainstream thinking if the eurozone economy performs well. Yet monetary tightening remains highly unlikely before the middle of 2019 and with the output gap much larger in the eurozone than is the case in the US, it is likely to take far longer for inflation to start moving in an upward direction. For now, scarcity remains an issue in European government bonds and it is unlikely to go away any time soon, whereas ultra-low deposit rates have served to anchor short dated bonds close to -0.7% creating a relatively steep yield curve in a stable rate environment. Consequently, we see the euro curve as anchored, relatively speaking, and likely to resist much of any move higher in US yields at a time when European and US monetary policies remain in diametrically opposed directions.
We remain biased to believe that a compromise will be found given the desire in the Republican Party to deliver a policy win
Newsflow in the UK over the past week has surrounded optimism that the UK is closing in on a compromise to move Brexit talks on to the next stage at the upcoming EU summit in the middle of December. However, we remain cautious in reading too much into this and recent meetings in Brussels and Westminster suggest that the gap between the two sides remains very wide. In Brussels, we detect some hope that the Brexit process may yet be stopped and this is acting as a disincentive for negotiators to give much ground at the current time. Meanwhile, the threat of an Irish veto remains a live issue, with a resolution on the border still appearing intractable. From the UK perspective, we have never really viewed the size of the divorce bill as the most difficult hurdle - as the sums are not dissimilar to the amount the government had to pump in to RBS and when defeased over 10 years, represent a moderate sum. However, as the Irish issue shows, with Brexit, the devil is in the detail and with many parties seeking to achieve different outcomes, we continue to see a high risk of a break-down in talk and a lurch towards a damaging 'hard' Brexit outcome, with blame being apportioned by both sides.
It is for these reasons we have maintained a negative view on both Gilts and the pound during recent months and in our view, it may be necessary for the UK to look into the abyss before changing course, which is why we have thought there is a very real prospect of another general election prior to March 2019. Such an election could easily deliver a victory to Jeremy Corbyn and see the UK move in a very different direction to the policy mix pursued today (something affirmed in meetings held in Westminster this week). Whilst it is not for us to judge whether this would be a good thing or a bad thing, we could easily see a scenario where the pound could rise on a Labour win, if it were more clearly apparent that a 'hard' Brexit could be averted and a European Economic Area (EEA) type deal more easily achieved. At the same time we would expect Gilt yields to be much higher under a Labour administration - yet if wages can rise along with prices and government spending, this could be seen as a good thing in some quarters. What seems clear to us is that there may be plenty of opportunities for investors as a result of what occurs in policy and politics in the UK in the months ahead.
In the week ahead, our focus will be very much of the passage of the US tax proposals through the US Senate and we will be in Washington seeking to assess these developments and attempting to better quantify the likely impact of any tax cuts on both growth and monetary policy in 2018 and 2019. We remain biased to believe that a compromise will be found given the desire in the Republican Party to deliver a policy win, though the next few days will be crucial given the desire to push things through ahead of the Alabama Senate race on 12 December. In our view, we have thought a package of tax cuts could easily end up benefitting US growth by 0.5% in the year ahead and with such a fiscal easing occurring at a time of full employment and when the economy does not need further stimulus, this will need to be met with additional tightening on the monetary policy side.
With financial conditions having eased in 2017, notwithstanding the Fed due to a softer US dollar, record stock markets and tighter bond spreads, we currently see the package of a tax bill leading us to push our projection of three rate hikes in 2018 to four moves, knowing that in current Fed discourse, no formal allowance has been made for tax cuts ahead of these being confirmed. With this being the case, we continue to see the risk of a December reflation trade and statistically it is interesting to see how historically Treasury market volatility normally dies into Thanksgiving before rising into the end of the year. In this context, December is normally one of the more volatile months of the year, partly thanks to thin liquidity conditions. In 2017, given the catalysts around the corner, we are inclined to think the same could hold true.