After more than a year since its last hike, the U.S. Federal Reserve is poised to cut its funds rate, one of the most critical interest rates in the U.S. financial system and, arguably, in the world. The U.S. central bank has been under mounting pressure to ease the cost of money for over a year, and inflation now appears to be on a stable downward trend.
Make no mistake: there are no compelling reasons to ease monetary policy. The US economy continues to perform well, with 3% GDP growth in Q2 and a 4.3% unemployment rate—far lower than the 5.7% average since 1990. More importantly, the forecast for Q3 GDP growth is above 2.5%. Access to credit, as measured by the Federal Reserve itself, is also ample. The most recent indicator shows that financial conditions are as loose as they were in January 2021, before the Fed started the current hiking cycle.
So, why is the Fed easing then? The simple answer is: debt. The U.S. economy is burdened with a debt-to-GDP ratio of 340%, with the Federal government accounting for 35% of that and households, corporations, and financial institutions sharing the remainder almost equally. For the last two years, financial institutions and the government have been pushing for the Fed to ease monetary policy. On the private side, the motivation stems from the dismal performance of the bond market; over the last three years, fixed income investors have been losing money on a total return basis, a scenario they thought could never happen.
More critically, several institutions, particularly those in the systemically important commercial real estate sector, are facing a 'maturity wall' and are eager to see lower rates ahead.
As for the government, higher interest rates mean that interest costs have skyrocketed and now exceed defense spending, further straining the U.S.'s fiscal capacity. Like many other developed nations, U.S. politics has long relied on deficits and debt. Higher rates accelerate the inevitable point where the debt burden becomes so overwhelming that central banks must step in, lower rates, and once again become the buyer of last resort. We've seen this scenario play out before, but this time the debts are much larger, and the global landscape has become far less cooperative.
Our readers know we were right and early in calling for 'higher for longer,' a critical insight that helped avoid the money-losing allocation to duration that most investment houses have advocated for over two years. While the case for a rate cut is questionable, barring a shock in the August CPI reading, a 25bps cut at the September meeting seems almost certain. However, the magnitude and timing of future cuts remain uncertain. Despite this, market participants have already priced in approximately 125bps of reductions, assuming that once the Fed begins easing, it will continue on something like automatic pilot. Yet, the weight of the evidence suggests such an outcome is far from assured, and bondholders may once again face a rude awakening.
The first argument centers on the inflation trend over the coming months. While the CPI currently stands at 2.9%, close to but not quite at the 2% target, history shows that in over 100 global inflation shocks over the past 54 years, inflation took more than 5 years to dissipate 40% of the time. Regardless of the outcome of the upcoming elections, the new U.S. administration is likely to pursue inflationary policies. This could happen through a combination of price controls and subsidies, which would restrict supply while boosting demand. Alternatively, inflation could be driven by tax cuts and tariffs on foreign goods. In summary, basic U.S. political game theory suggests that the Fed may prefer to err on the side of caution.
The other argument for a cautious approach to easing is the U.S. Treasury's insatiable appetite for bond issuance. In 2024, the total issuance, including both refinancing and new debt, will approach $11 trillion, which is approximately 38% of U.S. GDP. It doesn't take a Math PhD to understand that if debt grows faster than nominal GDP, the result is an unsustainable debt burden. This year, the economy is expected to grow by approximately 5.5%, while the deficit, which will soon convert into debt, is projected to grow by 6.5%. In 2025, we are likely to see lower nominal growth with a similar or possibly even higher debt/deficit.
It remains unclear who will purchase this massive amount of debt and at what interest rate. This scenario could lead investors to demand higher rates for longer-duration U.S. debt, potentially causing a brutal steepening of the yield curve. Something along the lines of what happened in the UK in Oct 2022 and led to the demise of Liz Truss, the then UK Prime Minister. Higher rates would increase the likelihood of a credit event, forcing the Fed to intervene by re-expanding its balance sheet. Such intervention would reignite inflationary pressures, create the risk of stagflation, and most importantly undermine global confidence in the U.S. dollar system.
The combination of inflation risks, U.S. politics, debt issuance, and geopolitical tensions is likely to lead the Fed to adopt a far more cautious easing cycle than what markets have currently priced in. In fact, there is a distinct possibility that, under various plausible U.S. political and geopolitical scenarios, we could see rates on the long end of the yield curve reaching new highs. Given this outlook, the weight of evidence suggests that bondholders, particularly those who have recently increased their duration exposure in hopes of a quick capital gain, may face more pain ahead.
Disclosure: Not investment advice. Do your own research. Hold all assets mentioned. Follow on X @pietroventani for more timely comments and updates.