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A Rolling Loan Gathers No Loss

Long end yields have recently broken to new cycle highs. From our perch, as we noted earlier this month, this likely reflects a few key factors but primarily macro resilience which is itself a plausible function of the fiscal impulse in the United States, Treasury issuance, emergency liquidity measures during the regional banking crisis in March and accumulated excess savings following the post-pandemic boom.

From a behavioural perspective, higher yields also probably reflect a reversal of first half positioning for disinflation and/or recession. The irony, as we see it, is that the lags in policy tightening will likely start to lead to a slowdown in cyclical pressures as we move toward the end of the year (our sense was that the cyclical risk was always likely to be later this year and not in the first half). The Fed balance sheet and liquidity has started to reverse, rates are now restrictive and the fiscal thrust in the first half of the year is unlikely to be repeated.

The rise in long end yields matter because the United States is a long rate economy – most private sector debt is priced off the long end of the yield curve. Of course, “fair value” of the long end is a function of future expected short rates plus a risk or term premium for inflation expectations. If the Federal Reserve maintains the funds rate higher-for-longer, combined with moderating expected inflation, that will tighten effective monetary conditions.

As we have noted recently, resilient macro conditions are plausibly a function of the fiscal impulse in the first half of the year. The fiscal thrust (change in the budget deficit) has been the third largest in post war history. Only 2020 and 2008 was greater (chart 1). While fiscal easing has likely been motivated by the next election in 2024, what is unusual is that it has been implemented at “full employment” (with unemployment below 4%). The forward-looking risk is that aggressive fiscal easing at full employment reignites inflation or leads to a second wave of inflation. We are not suggesting that this is the base case, however, it might be a reason why long-end yields are rising. Of course, it is also notable that bond yields are also rising in other developed economies, especially Japan.

We would also note that a key policy error in the 1960s-1970s was the aggressive fiscal easing to finance the Vietnam War at full employment. Prior to 1965, US core inflation was low and stable below 2% (chart 2). The acceleration in the rate of inflation occurred in the mid-1960s and eventually led to the break of the Gold Standard in 1971 and the more pernicious episodes of inflation in the 1970s that were amplified (not caused) by the oil shocks and policy error (of easing too soon) in the mid-1970s. As an aside, we would argue that any discussion of shifting the inflation target at Jackson Hole this week as misguided, foolhardy and therefore unlikely. As an astute observer noted, the Fed shifting their inflation goal is like an overweight person shifting their target weight to the current weight because it is too hard.

A related irony of aggressive fiscal easing in the United States (at full employment) is that China is probably not easing fiscal policy enough (youth unemployment is 21%). While there has been a lot of bear-porn related to China recently, the situation is legitimately dire. Lowering the lending rate by 10 basis points is probably not an effective policy response when construction starts are down by 55% and there is a massive inventory glut of around 27 trillion Yuan that must be re-balanced. Of course, as we have noted recently, widening interest rate differentials could amplify pressure on the currency. Another factor limiting a massive liquidity response might be bank profitability and balance sheets. Zhongzhi Enterprises going into forced restructuring might signal that contagion is starting to play out. A rolling loan gathers no loss. The challenge for many debt holders in China is that they can no longer roll over their debt. From our perch, the answer must be fiscal policy support of both growth and the liabilities on the central government balance sheet.

Our inner contrarian is very alert to the overwhelming sense of pessimism in China. Hong Kong listed Chinese equities have delivered virtually no return since 2007 and materially underperformed global equities since 2021 (chart 3). The market trades at under 10 times forward earnings and a 40% discount to world equities. The bear case is widely appreciated. A missing element is probably an emotional phase signalling a widespread capitulation in beliefs. Moreover, our sense is that fiscal easing is probably necessary in China. Perhaps the price action in iron ore today and Hong Kong listed equity is a signal that greater policy support is on the way?

We would also note that the prevailing bias is polar-opposite for US technology companies. The MSCI USA Information Technology Index trades on just under 7 times sales and only modestly below the 2000 and 2021 twin peaks of 8 times sales (chart 4). While the correlation between the performance of long duration growth equity and the discount rate (real Treasury yield) is not stable, a higher real yield eventually leads to a re-pricing of future cash flows lower. Embedded expectations and beliefs on mega-cap tech are heroic and vulnerable to disappointment (NVDIA) and a higher discount rate.

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