22nd September 2016

On 21 September the US Federal Reserve decided not to raise interest rates, but fourteen of the seventeen board members indicated that they expected one more rate rise in 2016. This has pretty much telegraphed to financial markets that, so long as economic statistics remain reasonable, the Fed will go for a rate rise at its December meeting.

This December is an excellent time for a rate rise, regardless of the state of the US economy, because it is a period of low public scrutiny. It has the advantage of being after November’s Presidential election but before the inauguration of the new President on 20 January 2017. Hence a rate rise at this time is much less controversial: the Fed is unlikely to attract criticism from either the lame-duck incumbent or his not-yet-installed replacement. In addition, December is when Congress holds its own lame-duck session of the old members, which usually attracts very little attention from the voters or the media. Aficionados of US economic history will recall that, back in 1980, Paul Volcker made use of this lapse in the public attention span to commence his round of rate rises.

Therefore, we believe that financial markets have already priced in the next US interest rate rise. What they have not yet priced in, however, is the coming shift from monetary policy to fiscal policy. Since the GFC, developed economies have tried to stimulate economic growth by means of very loose monetary policy, as represented by quantitative easing and ultra-low interest rates. It has become obvious that this has not worked, and that central banks have reached the limits of their policy instruments. As a result, governments are now looking at reviving the old Keynesian policy of government spending.

The US is furthest along this road: both Hillary Clinton and Donald Trump have promised a dramatic increase in spending on infrastructure. The Clinton policy is to spend USD$275 billion over five years. Trump has said that he will at least double this figure.

There is no doubt that US infrastructure needs this spending (with the exception of a wall on the Mexican border). Every two years, the American Society of Civil Engineers prepares a “Report Card” on the state of US infrastructure, from roads and bridges to schools and drinking water. Most categories rate no better than a grade of D or D minus, and the Society estimates that USD$3.6 trillion needs to be spent to bring US infrastructure up to scratch. As Kenneth Rogoff states so eloquently, “A visit to a primary school classroom in many US cities is the closest thing one can get to time travel”.

The UK government has already abandoned its post-GFC policy of austerity and is planning to stimulate the economy by infrastructure spending on roads and railways. Part of the reasoning behind the change is the need to offset the negative impact of Brexit. The new Chancellor of the Exchequer has said that he will “re-set fiscal policy” in a statement to be released on 23 November.

There is of course no guarantee that fiscal stimulus will succeed in reviving economic growth. For example, Japan’s intermittent fiscal stimuli in the last two decades has merely created temporary construction jobs and a lot of “bridges to nowhere”. Equally, Japan’s failures do not mean that other countries’ efforts must also be doomed to failure. It is important that spending should target productive assets rather than high-profile boondoggles and politicians’ vanity projects.

Whether the switch to fiscal policy succeeds or not, the mere fact that it is being tried will transform investors’ expectations in US and European bond markets. The initial impact will occur at the level of bond supply and demand: the need to fund the planned infrastructure spending will require the issue of more government bonds, i.e. an increase in supply without a matching increase in demand. Other things being equal, bond markets should react to this increase in supply by lowering bond prices, which implies raising bond yields.

We believe that this process has already begun. Yields for long-dated US and European bonds have risen in the last two months as the trend toward more infrastructure spending has become clear. We think that the US ten-year bond bottomed in July at a yield of 1.32%; it is now at 1.60%, and could rise by a lot more in the next few months.


A switch to fiscal policy will also affect inflation expectations. As the chart above shows, the Eurozone five-year forward swap rate has fallen steadily since 2012, to the point where it is now at a record low of 1.33%. This implies that the market is assuming that Eurozone inflation will remain at its current level of 0.2% per annum for the next five years. In view of the recent history of anaemic GDP growth and low inflation in the Eurozone, this has been a reasonable assumption – until now.


Similar charts can be drawn in the US, where interest rate expectations are slightly higher, but economic debate there is focused on the question whether the US economy has entered a period of “secular stagnation”. This is the theory that interest rates will remain low for the next decade or more because there has been a permanent decline in innovation or productivity or investment opportunities, which implies that the US has more savings than it can put to work profitably. A rise in fiscal stimulus does not prove or disprove this theory. What it does is push the theory aside in favour of the immediate question of where inflation and GDP growth will be in the next Presidential term.