Interest rates, budgets, bonds and the dollar

US economy could flatten with yield curve near inversion – Photo: Shutterstock

US President Joe Biden’s initial budget proposal for 2023 was released on Monday and the dollar remained relatively strong at the start of the week, although signals that a recession could be on the horizon began to proliferate.

As the military dispute between Russia and Ukraine, combined with soaring inflation and the continued fallout from the Covid-19 pandemic, plagued markets, the United States became increasingly hawks on monetary policy, seemingly day by day, while investors relished the relative stability of the dollar and the dollar. the American economy.

Still, volatility in Ukraine, a shrinking workforce, shifts in federal spending policy, new taxes, and analytical indications of a coming recession could shake up the macroeconomic landscape in the not-too-distant future.

Recession harbinger: the yield curve

Analysts at TD Economics and Deutsche Bank were among those who sounded the alarm bells on Tuesday, citing concerns beyond accelerating inflation and a tightening and contraction of the labor market.

TD economists Beata Caranci and James Orlando noted that the last period of aggressive interest rate hikes dates back to the mid-2000s and ultimately led to an about-face in the investment market. housing and a financial crisis. Today, the Fed (along with the Bank of Canada and other central institutions) faces soaring house prices and rapid inflation, while high debt levels indicate that a tightening could hamper growth. Although the Fed’s benchmark rate landing point is considerably lower today than it was then, other market conditions create equivalence, the economists wrote.

“Market participants are catching their breath as Fed ferocity has sent bond yields jumping more than a full percentage point since the start of 2022, reaching levels not seen since 2019,” Caranci and Orlando wrote.

The flattening, and now inverting, of the yield curve between two-year and 10-year Treasuries has widely raised concerns of a recession, even as US Federal Reserve Chairman Jerome Powell offered three historical examples of “soft landings,” where rate hikes occurred corrective functions without triggering a prolonged recession.

Caranci and Orlando noted that the current cycle is atypical, starting with the jarring impact of the pandemic and continuing with the conflict in Ukraine. As a result, the Fed began to base its policy decisions on real-time data rather than models and extrapolations. Although rational in its basis, economists felt that the execution of the strategy had created a high potential for policy errors, initially lagging behind the action warranted by economic circumstances and then having to rise too high, too abruptly.

“The Fed has consistently focused on the negative and downplayed or downplayed positive data that called for action,” the economists wrote. “This has been further minimized with their move away from reliance on the projection component of political decision-making. “Suddenly” the Fed found itself behind the curve.

Another negative sign

In addition to the more orthodox yield curve analysis, Deutsche Bank economists Matthew Luzzetti, Brent Ryan, Justin Weidner and analyst Amy Yang pointed to a less conventional indicator of a coming recession, consumer sentiment. Americans.

Over the past few months, the expiry of the child tax credit, the uphill battle of Covid restrictions, financial market volatility and the rising cost of living – fueled in large part by rising fuel prices. energy, heat, food and vehicles, among other commodities – have eroded consumer sentiment to its lowest level in more than 50 years.

“In response to these headwinds, an indicator we follow closely suggests that US households are the most pessimistic they have ever been on the outlook,” the DB Group wrote. “In particular, the gap between readings of current conditions in the University of Michigan and Conference Board surveys has fallen to the lowest level on record. Although somewhat obscure, we have written extensively in the past about how this difference exhibits a clear cyclicality, with the difference falling to very low levels before recessions.

While the yield curve is a stronger indicator of an impending recession, consumer confidence has about an 80% correlation with it and other traditional barometers, and has been shown to be more accurate than some other supplemental measures. , said the DB team.

“The most direct implication is that the slope of the yield curve should be significantly flatter. This also tells us that recession risks are high, with this consumption signal being consistent with a recession probability of around 50% over the next year,” the quartet wrote. “However, as with everything else [in] this cycle, one wonders if the pandemic has altered the signals. If inflation dissipates, labor supply returns and the effects of Covid diminish, we expect this gap to widen, sending a less pessimistic signal about the future.

The budget

Biden’s annual budget calls for $5.8 billion in spending with significant increases in military spending (nearly 10% to $773 billion), domestic spending (about 7% to $1.6 billion), infrastructure (including $115 billion provided for in last year’s infrastructure bill), future pandemic preparedness (the US Food and Drug Administration sees its budget increase by more than 30% to $8.4 billion dollars) and improving climate change (a 60% increase to $45 billion). The White House said the proposal could cut the budget deficit by $1 billion over the next decade as it tries to offset new spending with new taxation.

For the privileged few, about one-hundredth of Americans, the proposal also calls for a minimum tax on households with net worth over $100 million. They would be required to pay at least 20% not only of their income, but also of unrealized gains on assets such as stocks. The payments would be taken into account for the taxation of gains after the sale.

Overall, what the White House charges as its “billionaire minimum income tax” represents something of a steep turn for the Biden administration. He had largely avoided wealth tax calls from other members of the Democratic National Party, such as Senators Bernie Sanders and Elizabeth Warren. The US Senate is split evenly between Democrats and Republicans, with Vice President Kamala Harris holding the deciding vote, although moderate Democrats like Joe Manchin have crossed party lines, including over last year’s vote on the Build Back Better Act.

The 1% tax on share buybacks is of particular interest to companies and investors. It first appeared in the aforementioned infrastructure bill, which passed the House of Representatives but not the Senate, and has now resurfaced in the budget proposal.

S&P 500 companies repurchased some $882 billion in shares last year, with 2022 on track to exceed $1 billion in buybacks, as the use of the practice has become more widespread over the past decade.

In addition to the tax, there would be durations required for the period during which the shares are held by the directors. The administration’s stated goal is to “deter corporations from using their profits to buy back stock and enrich their executives, rather than investing in long-term growth and innovation.”

The dollar

Austere market sentiment initially helped the dollar as its index climbed well above 99 on Monday, plunging below 98.50 in a risky all-market session.

The dollar was also supported by difficult times for another generally stable currency, the Japanese yen. The yen was the worst performer among the main components of foreign exchange trading, hitting a seven-year low on Monday.

This was fueled by Japan’s decision to avoid the broader trend of monetary policy tightening – cuts in public investment, higher interest and lower stimulus spending – and the Bank of Japan’s decision to buy a unlimited number of 0.25% Japanese government bonds.

The second central bank intervention this year in Japan strengthened the US dollar as a sell-off pushed investors towards a more stable greenback.

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