Back in early August, I wrote about the finances of the USA, asking whether the Federal Reserve, the country's central bank, was in a position to stop raising interest rates.
My thinking then was that US inflation was looking like it was coming under control and that US equities could continue to make gains into year-end.
We are now almost three months further down the track and it seems like a good opportunity to revisit these topics and review the state of play.
What’s changed if anything?
Back in August, I was pretty confident that the Fed would be able to pause and ultimately stop raising interest rates. However, I did voice my concern about the state of US federal finances and specifically the overall national debt, the total amount of money that the US government owes to its creditors, and the budget deficit the amount of money the government spends, over and above what it raises in revenues, both of which were rising sharply.
This was something I felt the market couldn't continue to ignore
You see to bridge the gap between what it raises in taxes and what it spends on programmes, services and other budgetary commitments, the US government borrows money off of the bond markets.
Bond markets are happy to lend the US govt money because they believe the US govt will pay them back. After all it can hardly run out of a currency it can print at will.
However, bond investors also want to earn an appropriate return on the money they lend.
One that compensates them for opportunities forgone elsewhere and that reflects the level of risk they are taking in lending money to the US state. The returns that the bond receives are known as yield. Yields reflect current interest rates, expectations about future interest rates and any additional compensation demanded by the market to persuade them to lend their money to the borrower.
Interest rates havent moved
Interest rates in the US haven't changed since August with the Fed adopting a wait-and-see policy over its next move. Yet as we can see in the chart below the yield on the US 10-year bond has risen dramatically since then and has tested as high as 5.00%.
So why have we seen those moves in bond yields?
Well, one explanation would be that in the mind of the bond markets the risk of lending to the US government has increased, and therefore the bond market wants a bigger reward for taking that risk.
The market doesn't believe that the US government would default on its obligations (not yet anyway) but it does sense that its finances aren’t as strong as they should be and that the governments future obligations are mounting up.
Source: Trading Economics
Higher interest rates make existing debt more expensive to service and more expensive to replace or refinance.
For example, in the spring or summer of 2020, the Federal Reserve could issue five-year bonds at yields of less than 0.50%.
Today the bank would have to pay a yield of around 4.80% to get a similar bond issue away.
Why have attitudes changed?
Why has the bond market become less keen to lend to the US government? Well, we don't have to look too far for the answer. The US budget deficit for the fiscal (or tax year) 2023 came in at $1.695 trillion. A jump of 23.0% over the equivalent period in 2022. That sharp jump came about because revenues fell, as expenses rose.
Payments for social security, healthcare programs, and the cost of servicing the national debt all rose to create the largest US budget deficit on record, outside of the pandemic.
For his part, President Biden shows no signs of curbing spending indeed he wants Congress to grant him an additional $100 billion in foreign aid and security spending, much of which would be destined for Ukraine and Israel.
The Republican-dominated Congress is unlikely to want to play ball ahead of an election year or at least not without extracting major concessions from the Democrat-led White House.
Where has this left equity markets?
The S&P 500 has moved inversely, or in the opposite direction to 10-year bond yields, as we can see below. The truth is there hasn't been much in the way of bad news for US equities. We have seen some large-scale M&A activity, including two sizable deals in the Energy sector.
Source: Trading Economics
We have also started Q3 earning season on a positive note though it is still early days.
And yet the S&P 500 has fallen by more than -7.0% since the startt of August giving back a sizeable chunk of its year-to-date gains.
Source: Barchart.com
Notably the largest stocks,by market cap, in the S&P 500, remain well up on the year.
With Apple up by 33.0%, Microsoft by 37.0%, Alphabet by around 55.0%, and Nvidia by a whopping 194.0%.
Source: Barchart.com
Whilst many smaller stocks within the S&P 500 have had a tough 2023 thus far.
Source: Barchart.com
That polarised performance could well reflect the fact that “higher for longer” interest rates are bad news for less profitable companies. Or those with large debts, because just as is the case for the US government, those debts have become dearer to finance and renew.
What’s the year end outlook then?
It’s still not impossible for US equities to move higher before year end.
And the Fed may not to need to need to raise interest rates again, not least because the bond market is doing the central banks work for it.
Overall though investor sentiment needs a shot in the arm.
And the best place that could come from would be falling yields, especially if they were led downward, by lower inflation.
We are not seeing that right now, however, we will get the US October inflation print on November 14th, as well as manufacturing and services inflation data, in the first week of the month. So watch this space and the chart below.
US 10-Year bond yields over layed by US inflation prints.
Source: Trading Economics
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