The recent 50 basis point rise in long-term bond yields began the day after the Fed cut interest rates by 50 basis points (base rate 4.75% to 5%). Some of the bond bears argue that the Fed will reignite inflation by cutting interest rates as the economy remains strong. Others fear that fiscal deficits are out of control and leading with mathematical precision to a resurgence of inflationary pressures. A group of bond-focused investors worry that Donald Trump’s presidency and Republican control of Congress will increase deficits leading to high inflation. Let us examine the accounts and assess their credibility.
Will inflation rise again?
At its core, inflation is a function of supply and demand.
Inflation in the period 2022-2023 soared because demand increased greatly due to the policy of transfer payments given during the pandemic crisis, while at the same time the supply of many goods was reduced due to lockdowns and crippled supply chains. Both demand and supply have since leveled off. So if inflation rises, it will not have the same causes.
1970s Rerun
Some investors argue that we had consecutive inflationary rounds in the 1970s and, unfortunately, History will repeat itself. However, that time and “now” are different… “The 2020s are not the 1970s by any stretch of the imagination!”
Government spending
Uncontrolled federal deficits will fuel inflation. Before we debunk deficits, it’s worth mentioning an economic term called the negative multiplier:
Debt growing faster than economic growth means that borrowing and spending are unproductive.
Non-productive public debt or private sector debt also results in a negative economic multiplier.
Essentially, the final cost of debt exceeds its benefits in the long run.
Economists define the multiplier effect as the change in income divided by the change in expenditure.
Over an extended period, if the change in expenditure is more significant than the change in income, the effect of said expenditure is negative.
Substitute GDP for income and government debt for spending to calculate the government spending multiplier.
Multiplier = Change in Income / Change in Expenses
Government multiplier = Change in GDP / Change in outstanding debt
Conclusion: public debt stimulates the economy. However, the product of time reduces growth rather than compensates for the initial benefits.
If you believe that the government is suddenly spending productively, then inflation may be on an upward trajectory. However, assuming the government continues to spend unproductively, higher deficits are deflationary and weigh on economic growth.
The US will introduce inflation
Some say the US will introduce inflation.
The first chart below shows that inflation in the Eurozone, China and the United Kingdom, three of America’s largest trading partners, is falling alongside that of the United States.
China’s inflation is almost zero.
Japan, not shown, has seen meager inflation with periods of deflation over the past 25 years. We also ran a multiple regression to predict US inflation against China, UK and Eurozone inflation. The second graph shows a significant correlation, with an r-squared of 0.86. In addition, the model states that the US CPI needs to decline by 0.3% to align with the historical relationship.
Demystifying deficits
Before we put recent deficit spending into context, it’s important to point out that continued deficit spending and the nation’s accumulated debt are a significant headwind to economic growth.
We also know well that countries with debt-to-GDP ratios above 1.0 have never done well.
That said, when looking at bond yields over the next couple of years, we need to assess the situation as it stands today and not let the narratives and hype around the market sway our decision-making.
Let us now “visit” some popular arguments that the trajectory of deficits has changed, and the change is inflationary.
Recent expenses
A common argument of bond “bears” is that recent deficits are too large compared to past ones.
They believe these increased deficits will be inflationary and require higher yields to satisfy investors.
While this may be true, the argument lacks context.
At the same time, they fail to mention that the economy has grown significantly in recent years. The economy is about $8 trillion, or 33%, larger than it was on the eve of the pandemic. Therefore, it is not surprising that the amount of debt has increased in proportion to GDP.
The graph below shows the debt to GDP ratio and its trend line from 1980 onwards. After the ratio spiked higher due to massive COVID-related spending, it fell slightly above the pre-pandemic point. In addition, the last two years have been flat…
Now, let’s take the analysis a step further and theoretically calculate where the debt would have been if the Pandemic had never happened. In advance, we admit that this is not a traditional way of assessing debt, but it does provide a unique context for outstanding debt compared to GDP. To do this, we are reducing the debt by the estimated $5.6 trillion spent due to COVID. Furthermore, we assume that debt interest would have remained at the pre-inflationary trend. In perspective, this shaves off about $500 billion in additional interest expense over the past year. The chart below shows the revised debt to GDP in orange.
Would it be fair to say that without the Pandemic, current debt issuance would be equivalent to pre-pandemic debt to GDP, given the size of the economy? Moreover, despite the pandemic, spending, debt and GDP growth have all aligned over the past two years.
Deficit spending increases the money supply
Larger deficits (borrowing) increase the money supply.
However, as the chart below shows, the M2 index is in a COVID mood. More importantly, M2 as a percentage of GDP, a better measure of the money supply, is lower than the pre-Covid trend.
Also, the money supply is a part of the inflation equation. The other important half is the speed at which money flows, or how often it is spent.
Currently, M2 velocity is on par with early 2020. Money supply and velocity have erased pandemic-related anomalies and are similar to what they were at the end of 2019.
At the time, inflation was running steadily at 2%. The current supply and velocity of money should not lead one to believe that inflation is going to rise. If anything, the evidence suggests that inflation will return to the Fed’s 2% target.
We follow the path of Japan
A similarity between the fiscal situation of the US and Japan. He makes reference to Japan’s excessive public debt and its central bank, which keeps interest rates extremely low to help service the debt.
Japan has a debt to GDP ratio of 263%, more than twice that of the US. Its central bank has set interest rates below zero and for the past 20 years has relied on massive QE. The result is that longer-term bond yields fall.
Inflating the debt is the only way to solve the problem without severe fiscal measures. But Japan is proving that this is not necessarily the case – at least not yet. Debt to GDP is stable and not increasing.
Donald Trump
Let’s assume that Donald Trump immediately attempts to cut taxes, spend like crazy and create huge deficits upon assuming the Presidency. Even so, he must contend with Democrats, who will still hold nearly 50 percent of the vote in Congress, and the Republican Freedom Caucus, which wants to cut government spending and balance budgets.
Conclusion
We believe that the slowdown in economic growth and lower inflation trends that were still prevailing before the pandemic are being reconfirmed. It may sound ridiculous today, but we wouldn’t be shocked if investors and the Fed worried about deflation again in the coming years.
