What the Mid-terms Could Mean for Interest Rates

Last Week: Interest rates staged a sustained rise and global equities clawed back some of their recent losses to close out one of the most volatile months in quite a while. The yield on the 10-year US Treasury note rose 9 basis points this week, to 3.17%, helped in part by Friday’s upbeat employment data. 1-month LIBOR continued its nearly uninterrupted ascent, rising to 2.3178%, up from 2.9938% this time last week.  Oil fell $3 a barrel to $63.14, a seven-month low, on rising inventories, as the US Dollar followed suit and Gold wrapped the week nearly unchanged. Treasury yield volatility, as measured by the Chicago Board Options Exchange Treasury Yield Volatility Index (TYVIX), rose slightly to 4.58 from nearly 4.34 a week ago.

The breadth of US job creation remains solid. Last Friday’s October jobs report showed that nonfarm payrolls rose a stronger-than-expected 250K while the unemployment rate held steady at 3.7%. Average hourly earnings (aka wages) rose 3.1% compared to a year ago, the biggest gain since 2009. The strong labor data parallels a jump in US consumer confidence to the highest level in 18 years, as those surveyed looked past volatile October financial markets. The underlying dynamics favor continued strong job growth and a further decline in unemployment by year-end.  All told, the data reassured markets and the Fed that America’s economy remains on solid footing across most economic sectors, wage pressures are gradually building, and escalating trade tensions aren’t being glossed-over by short-lived fiscal stimulus stemming from tax reform. The data emboldens the Fed to hike 0.25% at its December 19th meeting, assuming there’s no financial market blow-up before then.

More signs emerge that China’s economy is slowing amid a deepening US trade war, tighter global financial conditions and a slowdown in global growth. The Chinese government announced yet another package of targeted stimulus measures to try to prop up demand and counter the cyclical downturn. In a sign the growth slowdown is now extending to China’s neighbors, data from South Korea and Taiwan, both important parts of China’s supply chain, showed that they, too, have been caught in the regional downdraft, with industrial production figures and purchasing managers’ indices pointing to slower growth amid lagging global demand.

A small glimmer of hope on resolution of the US-China trade war. President Trump tweeted that he had had a “very good” telephone conversation with Chinese president Xi Jinping and that trade discussions are moving along productively ahead of planned talks between the two leaders at the G20 meeting in Argentina later this month. While expectations for a deal at the meeting are still very low, Trump’s tweet raised hopes that the trade spat, which has been weighing on financial markets in both the US and China, could be broken sooner than expected. As we’ve stated repeatedly, China will ultimately cave to many US demands as its economy is much more vulnerable to all the negative consequences – like much slower economic growth and the job losses that come with it – that a prolonged trade impasse would bring. We don’t expect anything substantial to be accomplished on the issue between the two leaders until early next year at soonest.

European growth continues to slow. European economic growth slipped into a lower gear in the third quarter, coming in well below expectations at just a 1.7% annual growth rate, down from a 2.2% rate in Q2. The growth rate peaked at 2.8% in mid-2017 and has been declining for the last four quarters. Italian growth ground to a halt in Q3 amid an ongoing battle between Rome and Brussels over Italy’s proposed 2019 budget, a framework the European Union has rejected and called unsustainable because of Italy’s high debt-to-GDP ratio. Any continuing deterioration in Europe’s economy and a strengthening in America’s will serve to erode US Treasury yields somewhat as global investors look from Europe to the US for higher yields.

Orderly Brexit could trigger more BOE rate hikes. The Bank of England signaled that UK interest rates could be raised more quickly if a deal is reached effecting an orderly UK exit from the European Union. The central bank said the economy is operating at full capacity while inflation is above target. This, along with hopes for a deal allowing UK banks to provide financial service within the EU, helped spark a more than 2.5% rally in the British pound versus the US dollar late in the week.

What to Watch This Week: US politics will take center stage tomorrow – overwhelming even Thursday’s Federal Reserve meeting – as congressional and some governors races remain highly contested.

While no one expects the Fed to hike at this week’s “non-event” meeting, it is the last one this year that won’t be followed by a press conference. With markets pricing in roughly a 70% chance of a December rate hike at present, the Fed won’t need to change its message in this week’s post-meeting statement, which should continue to imply that America’s economy is performing well enough to justify a continuation of its “gradual” policy mantra for the foreseeable future.

Take-Away: How could the results of the mid-terms election affect the economy and interest rates? Here’s your cheat sheet –

  • Democrats flip the House and Republicans retain the Senate. Such an outcome – a divided Congress – would make it more difficult for the Trump administration to further its pro-business agenda, and potentially usher in political gridlock that could slow economic growth. The President would have to rely more explicitly on executive orders to get anything done, and a second round of tax cuts would be dead-on-arrival as would most other significant legislative measures, outside of a bipartisan infrastructure initiative, which both parties want. The President’s hard-ball stance toward China on the trade front would also be second-guessed, benefiting the Chinese yuan. Overall, the scenario would likely take some wind out of the Fed’s sails for continuing to hike rates throughout 2019, as any planned government spending driven economic boost would be curtailed just as growth begins to plateau/decline. In such a scenario, we’d expect at least three more 0.25% hikes in the Fed’s current cycle regardless, and for the ascent of Treasury yields to slow as many investors use Treasuries to hedge against any weakness in global growth, stocks and emerging-market debt.
  • Republicans sweep both the Senate and Congress. The chances of increased government spending would skyrocket, pushing the economy into overdrive, boosting Treasury yields and creating a drag for stocks as the effects of tax cuts wane and the probability of higher inflation encourages the Fed to keep hiking. Thus far in the Trump presidency, Treasury yields have risen on the back of a solid economy and a pullback in monetary stimulus by the Fed. In a Republican sweep, this dynamic would continue, but at a more moderate pace, as confidence grows that U.S. economic growth will likely remain well above 2%, and that inflation remains close to or exceeds the Fed’s 2% percent target.
  • Democrats sweep both the Senate and Congress. Such an outcome would make it extremely difficult for the Trump administration to further its pro-business agenda, resulting in a grid-lock scenario for the administration. The President would have to rely exclusively on executive orders to get anything done, and the administration’s attempt at a second round of tax cuts would be a non-starter. The President’s trade stance toward China would be heavily criticized, but would ultimately endure, albeit on a less aggressive path. The political environment would also become more scandal-laden, as the now Democratic controlled House and Senate dig up all they can to slight the administration and squash its credibility and policy ethics. Overall, the scenario would slow the Fed’s hiking path as the administration’s turbo-charged, economic-boosting spending initiatives become much less likely to occur, ensuring that the pace of growth settles into a lower gear. In such a scenario, we’d expect at least two more 0.25% hikes in the Fed’s current cycle, and for the ascent of Treasury yields to slow more dramatically a be ultimately cut short.

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Source: Bloomberg Professional

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Source: Bloomberg Professional