January Rates Update

Monthly Commentary

February 01, 2017

As the first month of 2017 draws to a close, it appears that global monetary policy has started to give up its pole position as the sole catalyst of market prices. Indeed, January saw the market take cues not only from macroeconomic data but also based on developments in the political sphere. That is not to say that the global geopolitical backdrop has not been a determinant of price in past years, but given the new U.S. administration’s penchant for high-touch communication with its constituency, the political component of global macroeconomics seems to be moving toward the forefront. Interestingly, despite a flurry of protectionist-centric executive orders coming out of the White House, financial markets did not experience the same risk-off price action this month that has characterized the past two Januaries. This may be because the market has recalibrated itself to adjust for Q1 disappointments but could also indicate that the market still expects the new administration’s probusiness tilt to be supportive of economic growth over the medium term.

In the most anticipated event of the month, if not all of 2017, Donald Trump was confirmed as the 45th President of the United States. “From this day forward it is going to be only America first,” Trump said in his inaugural address after being sworn in, adding that the U.S. policy will be to “buy American and hire American.” Investors can interpret Trump’s America First agenda broadly as an effort to dramatically reduce the U.S. current account deficit and become more competitive in global trade. In recent days, President Trump has indicated he plans to renegotiate NAFTA, address what he perceives as predatory trading practices by Chinese firms, and encourage U.S. exports with tax legislation as he the aims to improve the U.S. trade balance. To aid the U.S. in improving its trade balance, House Republicans are pushing for a major overhaul of the existing tax code, including potentially adding a border tax that would effectively subsidize exports and tax imports. A central component of their plan is the replacement of the existing corporate income tax with a destination-based cash flow tax, which is similar to the value add tax (VAT) utilized by the European Union. Key features of this proposed plan include: Cutting the current federal corporate tax from 35% to 20%, allowing businesses to depreciate capital expenditures immediately and prohibiting businesses from deducting interest expenses when calculating their tax bills and moving to a system of taxing only the value added of goods consumed in the U.S.. This proposed plan is only one of several so the eventual legislation could look significantly different than what is currently being discussed but President Trump has made it clear his policies will be supportive of American exporters in some form.

Given that the annual U.S. trade deficit currently stands at $500 billion, a border tax rate of 20% would raise $100 billion in additional revenue all else equal. Currently, corporate income tax brings in about $350 billion each year, this new value add tax could allow corporate taxes to be substantially cut without any loss in overall revenue. The market may already be starting to price in this new paradigm for trade which favors American exporters over American importers as importer, Walmart has lagged the S&P 500 by 12% since the election while, exporter Boeing has outperformed the S&P by 11%. It remains to be seen what the final version of U.S. corporate tax reform will ultimately look like, but it is a reasonable assumption that any legislation will favor domestic exporters while penalizing importers for their use of non-U.S. based goods or services.

While a new domestically focused trade policy may benefit a portion of American companies and workers, the unintended consequences of trying to improve the U.S. current account balance could prove to be non-trivial. If ultimately the legislation passed by Congress provides an outsized benefit to domestic producers, global financial conditions could tighten meaningfully as more U.S. dollars are repatriated from abroad by U.S. corporations, decreasing the supply of dollars available in global credit markets. Not only would this capital flight back to the U.S. increase the value of the dollar, in turn putting downward pressure on U.S. inflation, foreign based borrowers of USD would see the value of their liability grow as the dollar appreciates against their local currency. As an estimate of the magnitude of this liability increase, a recent report circulated by a conservative Washington think tank estimates the debt burden for companies and states in developing countries with U.S. dollar liabilities would jump by $750 billion as a result of the change in tax policy. Additionally, the managed devaluation of the Chinese yuan currently underway would become significantly harder to manage as capital flight out of the yuan could increase as the dollar strengthened against the yuan. A rapid yuan devaluation could cause a disinflationary shock globally as a cheaper currency and excess capacity would exert downward pressure on prices outside of China. Although none of the consequences mentioned are explicitly a U.S.-centric problem, it would be difficult to imagine a scenario where the U.S. is able to escape an increase in global deflationary pressures unscathed. It is still early days in the Trump administration so proposed policies are subject to change, but at least initially, it appears that his desire to increase the America’s relevance in global trade may be inhibited by his own strong dollar politics.

Though the FOMC took a backseat to the changes on Capitol Hill that took place this month, it is still quite notable that FOMC Chair Yellen appeared at two speaking engagements to discuss monetary policy. On net, the two speeches did not do much to illuminate the FOMC’s future plans but Chair Yellen did note that she and most of her colleagues expect a few rate hikes this year. What was not discussed, however, was her view on the FOMC’s ability to taper their balance sheet down from $4.5 trillion. The topic of a potential reduction in balance sheet size had been a popular one in January, as several regional Federal Reserve Bank Presidents voiced a desire to start reducing reinvestment of maturing assets on the Fed balance sheet as an alternative to increasing the federal funds rate. It is still unclear though, if this desire to reduce the FOMC’s SOMA portfolio is simply postulation from noncore members of the FOMC, or if this alternative method to tightening monetary policy has gained traction within the committee as a whole.

To close out the month’s macroeconomic events, the Bank of Japan (BoJ) kept its policy on hold as expected at its month end policy meeting. The policy rate will remain at -0.1%, while JGB purchases should continue to track around ¥80 trillion annually but will continue to target a 10y JGB yield around zero meaning the BoJ may adjust the size of their purchasing operations depending on yield levels. Surprisingly, the BoJ did make upward adjustments to its real GDP forecasts for 2017 and 2018 and now look for 1.5% growth in 2017, up from 1.3% and 1.1% in 2018, up from 0.9%. These upward revisions for growth come as a result of the BoJ’s confidence that a weaker Yen will improve exports, which just turned positive for the first time in 14 months. However, in order for growth to meaningfully improve, Japanese consumption will have to break out of its current flat trend which has seen real private consumption average a meager 0.15% growth QoQ since 2011.

Although the Treasury market held steady in January, with 30y bonds closing the month virtually unchanged at a yield of 3.06%, it appears that the market dynamics of 2017 will be somewhat different than years past. Whereas 2015 and 2016 saw no real catalyst for upside economic surprise, the potential for lower personal and corporate taxes, less regulation and more fiscal spending from the new U.S. administration gives risk markets more positive potential outcomes to discount. That is not to say that any or all of the potentially positive catalysts will come to pass but the increase in potential constructive outcomes provides a more balanced skew of risks for financial markets than seen recently. Regardless of the eventual realized outcome, the confluence of potential macroeconomic catalysts has 2017 shaping up to be a fascinating year for financial markets.

Source: Bloomberg Barclays Live

U.S. Trade Balance of Goods and Services ($bln)

Source: Bloomberg

10y Japanese Government Bond Yield

Source: Bloomberg

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