We see two key drivers for the US Treasury market over the coming weeks: the path of the US economy and the possible outcomes and investment consequences of the US elections in November.
We believe September’s stronger-than-expected labour market report was ‘more noise than signal’ and does not indicate a renewed surge in US economic growth. In our view, the US economy remains on a path towards a so-called soft landing, with core inflation set to gently descend to the Federal Reserve’s 2% target (or slightly above).
Looking at the broad range of labour market indicators, we see a job market that has rebalanced despite historically strong output and employment growth, suggesting that the economy is operating beneath its (currently elevated) potential growth rate.
At the Jackson Hole conference, Chair Jerome Powell noted the Fed’s comfort with inflation, but also its concern over upside unemployment risks. These worries justified the Fed’s 50bp interest rate cut in September.
Even if the Fed upgraded its assessment of labour market conditions, we believe the argument for returning rates to neutral would remain valid. Neutrality for the fed funds rate, to our mind, is probably 3%, but could be as high as 3.5%.
US policy rates and the elections
It is difficult to make a call on the path for US policy rates independently of a view on the US elections. The result is on a knife-edge — and the uncertainty and unpredictability of the investment implications appear to be dissuading many investors from taking large active positions. Nevertheless, as election day approaches, we see brave investors taking positions, and hesitant investors establishing hedges.
Should Vice-President Harris win the White House, we deem it unlikely that the Democrats will also win control of the Senate (Realclearpolling.com has Republicans winning 51 seats to 44 for Democrats with 5 toss-ups as at 22 October 2024).
This would limit her room for maneuvre on fiscal policy and require compromise with Republicans in Congress to pass legislative priorities such as an expansion of child tax credits.
We would expect a portion of the Trump tax cuts to expire, but spending to keep increasing, leading to modestly larger deficits. Immigration policy would likely be tightened. The impact on growth and inflation would probably be modest in the first years of Harris’s term, permitting the Fed to proceed with cutting rates to neutral.
A second Trump presidency, however, could reshape US trade, immigration, regulatory, tax and spending policies — though changes to fiscal policy would require the assent of Congress.
Of particular relevance are Trump’s proposals to:
- Tighten immigration controls, which would, over time, reduce labour force growth and potential GDP growth
- Impose tariffs, either in a targeted fashion or on all imports, at rates between 10% and 60%
- Cut corporate taxes from 21% to 15% and extend the 2017 personal tax cuts expiring in 2026, thereby providing a significant fiscal impulse, but widening deficits further (at a potential cost of up to USD 6 trillion over the next decade)
Although some of these proposals are likely merely election promises, or require the approval of Congress, the first two could be delivered using presidential executive powers.
On the one hand, lower taxes and deregulation should boost growth. On the other hand, erecting trade barriers, imposing tariffs and tightening immigration would raise prices, constrain competition and reduce labour supply. This could be expected to damage growth over the medium to longer term — leading to a stagflation scenario.
Should Trump be in a position to enact his full range of tax and spending proposals, the potential consequences for US federal debt sustainability would be significant, and likely elicit a sharp market reaction from displeased Treasury investors.
The Penn Wharton Budget Model has estimated the deficit impact of Trump’s fiscal plans at nearly USD 4 trillion over 2026-2034, while the Committee for a Responsible Federal Budget has costed it at USD 7.5 trillion (versus USD 1 trillion and USD 3.5 trillion for the Harris plan, respectively).
Our view is that the inflation and debt sustainability risks associated with a Trump presidency (especially in a Republican sweep scenario) are not fully priced by the market.
We anticipate policy rates will not decline as much as previously expected following the strong job market data and the possibility of a Republican win (Realclearpolling.com puts the odds of a Trump victory at 60.1% as at 22 October 2024).
A rise in term premia, as investors balk at forthcoming supply in the absence of central bank bond purchases, could lead to a steeper yield curve. This might not happen, however, in the event of a second Trump administration.
We see breakeven inflation rates rising as we believe they are currently cheap and they would be supported by worsening Middle East tensions and higher oil prices, and/or if investors start anticipating inflationary policies from a Trump administration.
Eurozone – In sharp contrast to the US
We expect moderate aggregate economic growth, but at an unevern rate across sectors and member states, with core economies continuing to underperform.
As the slump in the manufacturing sector deepens, the services sector has been the sole support to growth.
The weakness in Germany’s economy reflects the structural challenges faced by its manufacturing sector, which was hit hard by the energy shock.
In France, the fiscal situation has worsened. Reform is needed as is consolidation against a fragile political backdrop. In contrast, more services-driven economies, such as Spain’s, will likely continue to see better growth.
The jobless rate also diverges across countries. It has risen in Germany, while in aggregate, the labour market in the eurozone remains fairly tight, but it has started to loosen.
Wage growth will likely remain high, but is set to slow. The gradual moderation in wage growth means that further improvement in underlying inflation over the rest of 2024 will likely be limited, as the ‘quick wins’ of lower goods and energy inflation are discounted.
The rise in inflation-adjusted household income as a result of high wage growth and falling inflation should support consumption. We note, however, that consumption has disappointed recently, especially in core economies, as saving rates are high.
On the fiscal front, European Union rules and the associated Excessive Deficit Procedures (EDP) will increasingly come into focus. While we do not expect fiscal austerity to return, an easier monetary policy might be required to balance the negative impacts from the tighter fiscal stance.
In balancing a slightly weaker growth outlook with still-sticky price pressures, we believe the European Central Bank (ECB) is likely to normalise policy gradually until the depo rate reaches around 2.25%, a level we would consider broadly neutral.
At the time of writing, front-dated interest rate pricing implies an ECB depo rate at around 2% by the third quarter of 2025, which we see as largely fair. That said, recent data highlighted rising downside risks to growth, which in turn could help inflation to moderate a little more quickly than currently assumed.
This is sharp contrast to the US, where the Atlanta Fed’s GDPNow estimate is tracking growth at around 3.4%. As a result, we would expect eurozone government bonds to outperform US Treasuries.
Diverging risks around growth and outlooks
We expect long-dated eurozone breakeven inflation (BEI) to underperform US BEI, reflecting the divergence of risks around the growth in the two regions. In addition, the possibility of a Republican sweep could lead to further divergence.
We see room for US BEI to outperform as market participants look to hedge against Trump’s potentially inflationary trade, immigration and fiscal policy proposals.
In country selection, we expect outperformance of German and Spanish inflation-linked bonds (ILBs) relative to France and Italy.
For German ILBs, we believe higher valuations are warranted on a relative basis due to their scarcity and a higher sovereign credit rating.
We see Spanish ILBs outperforming given the stronger economic growth relative to core eurozone countries. The services sector in Spain remains dynamic, and investment flows from Next Generation EU (NGEU) funds further support growth.
In France, although the short-term risk of a government collapse and the subsequent failure to pass the budget has decreased, Prime Minister Barnier faces the challenging task of consolidating public finances at a time when the fragmentation of parliament and infighting in his minority government will make it hard to push through reforms.
French and Italian government bond spreads over German Bunds could see renewed widening pressure as budget negotiations under the reintroduction of EU fiscal rule come into focus.
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