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The U.S. Federal Reserve raised its policy rate from 0.50% to 0.75% last week, as expected. And while the Fed essentially left its previous projections for the U.S. economy intact, it is now positioning the U.S. bond market for three additional rate hikes in 2017 (up from two hikes in its prior forecast).
The Fed’s forecasts have been wide of the mark for years (it had previously forecast three hikes in 2016) but bond-market investors seem to be buying the Fed’s view more so now than they have over the past several years, and that has pushed U.S. bond yields sharply higher.
The current narrative is that President-elect Trump will push through corporate tax cuts that will spur business investment and increase the demand for (and cost of) labour, and that he will also introduce massive new infrastructure-spending initiatives. If these developments play out as expected they will portend higher inflation, and investors are driving up U.S. bond yields in anticipation of this outcome (and they are taking Canadian bond yields, and our fixed mortgage rates, along for the ride).
Time to scratch my contrarian itch.
While the two Trump-led initiatives outlined above would be inflationary on their own, we need to consider their impact against a broad backdrop of other factors. For starters, will President-elect Trump’s own party support tax cuts that increase the deficit? I doubt it. And will they support fiscal stimulus that does the same, especially at a time when Federal Reserve Chair Yellen has just expressed her unequivocal opinion that the U.S. economy doesn’t need fiscal stimulus at this time?
Even if those tax cuts are pushed through, will businesses suddenly find the confidence to invest in productivity enhancements and capacity expansion with President-elect Trump holding fast to his protectionist agenda? If long-standing trade deals are under threat, is now a good time to be doubling down on investment, or would the safer option be to return any tax windfalls to shareholders? I know what I would be doing if I were sitting in a corner office and had to make that call.
What about the long-term factors that have pushed inflation down to its current low levels? President-elect Trump can’t do anything about the inherently disinflationary effects of an aging population. The U.S. economy is cranking out new retirees at record rates and will continue to do so for years to come. The surging U.S. dollar that has accompanied the recent spike in U.S. bond yields is another powerful deflationary force and record U.S. debt levels will continue to be a lode stone that exerts a inexorable drag on U.S. economic growth rates.
I could go on, but suffice it to say that when I look at the severity of the recent bond-yield run up I am reminded of a famous observation by Benjamin Graham about financial markets being a voting machine over the short term but a weighing machine over the long term. While there is no denying which way the momentum arrow is pointing at the moment, I think the threat of higher inflation that has caused the recent bond-yield spike will not materialize as the market now expects.
Of course, if you need a mortgage in the near future that prediction offers only cold comfort. Perhaps this next section will provide you with something more tangible to work with.