What happens to US and UK interest rates is key to our approach to investing in fixed income markets, because a large proportion of the bonds we invest in are denominated in those two currencies. The first thing to point out is that there is a very high correlation between US and UK interest rates.
Ten-year rates for both countries are now close enough to 4.5%, below their recent peak but elevated versus the last decade, and the question must be what happens from here in the new post-election and (for the UK) post-Budget world.
The rise in the UK ten-year rate is attributed to the certainty of the spending implications in Rachel Reeves’ Autumn Budget outweighing the lack of certainty that surrounds the anticipated tax revenues that Reeves hopes will contribute to balancing the budget. The move from 3.7% in September to 4.5% in mid-November 2024 can be interpreted as bond investors or 'bond vigilantes' warning Rachel Reeves not to replicate the mistakes of Liz Truss and Kwasi Kwarteng, whose promises to increase spending triggered a bond market revolt with ten-year yields spiking dramatically.
The near identical recent hike in the US ten-year rate is attributed to Trump’s more inflationary agenda and the run-on implication for higher interest rates needed to contain inflation. Import tariffs are inflationary because they raise the price of imported goods for Americans. Higher federal spending that is unmatched with tax receipts has to be financed by issuing bonds. At the start of Trump’s policy implementation, expect the extra spending to find its way into the economy by boosting both demand and prices in the short term; it takes factories a certain amount of time to build new capacity to meet new long-term demand. These factors have led us to hike our expectations for the long-term neutral rate for the USA from 3% to 3.75%. The neutral rate is the stable rate that gives stable trend growth, full employment and inflation, with our higher expectation for this metric based on the inflationary pressures discussed above.
A line exists for Donald Trump – we just don’t precisely know where it is.
Beyond the short term, the question that bugs us most is how sustainable the US deficit is. The USA has two advantages over the UK in that the dollar is both the world’s reserve currency and the currency of global trade. The reserve currency status means that the world has demand for trillions of US dollars and US government debt which drives lower rates for America. Trillions of US dollars are sitting in USD current accounts not earning interest but more to the point, not costing the US government anything to print those dollars. By costing, I mean that the US government does not pay interest on US dollar bills.
As things stand, by 2034 publicly held debt-to-GDP is likely to increase from the existing Congressional Budget Office baseline of 125% to something in the region of 145%, likely increasing borrowing costs. This forecast for publicly held debt-to-GDP could be problematic for the Fed because the deficit will need to be top of mind when planning monetary policy.
Liz Truss discovered that there is a line in the sand beyond which the markets will not go, when her plans caused a bond market revolt and spike in borrowing costs. A line exists for Donald Trump – we just don’t precisely know where it is. Does the line sit at 145%? Or higher? Or lower? Our estimates are at higher levels and that leaves us optimistic for the future.
