The IEEAP Shock
In yesterday’s press conference, Trump's comments about rates being “far too high” hit a snare.
Rather than rallying, Treasuries are looking at the ghost of Liz Truss, whereas in the UK, fiscal rules are “within a whisker” to be breached. UK Gilts are another seven basis points higher and are leading global rates.
Trump’s push for lower rates is viewed similarly if the Fed is cornered into rate cuts; such a situation could overheat the economy and worsen the deficit as yields lift over 5 percent.
Liz Truss has arrived in the forward market for Treasuries. The 10Y yield discounted forward ten years from today, which encapsulates expectations of future deficits, hit 5.43%, the highest since pre-GFC. Treasury forward yields follow UK Gilts, which are marching towards 6 percent (see Figure 1).
A fiscal crisis in the US is manufactured by an economy that could grow faster at 5% GDP while at risk of overheating. On top of this, CNN reported that Trump enacted the IEEAP to implement universal tariffs.
The law from 1977 gives the president sweeping powers in the event of an unusual and extraordinary threat to the national security, foreign policy, or economy that originates "in whole or substantial part outside the United States.”
Markets take this like a "Nixon price shock:" The unknown is not the tariff but how the universal part impacts price setting under an emergency declaration. Yields react particularly sensitively.
Figure 1: UK and Treasury forward yields (%)
Source: UK DMO, US Treasury
For the market technicians, a full retracement of yields is getting close. The 10Y has remained above the 76% retracement of 4.5% support from the 2007 high to the 2020 low.
The road to full retracement has no forks left; if the Fed cuts rates while universal tariffs are an economic fact, the 10Y yield will likely breach 2007 highs of 5.35 percent. This could elevate US fiscal risk.
Figure 2: Retracements
Source: Bloomberg
It sounds like a broken record (literally), but Liz Truss's fiscal risk is not a UK domestic affair.
The debt brake is a universal rule accepted by every investor in sovereign bonds. In the case of the US, matters are worse: GDP is set to rise due to investment driven by reshoring, funded with (record) corporate issuance hedged with Treasuries.
As (forward) yields rise, the debt cost balloons. For every 10 basis points, the cost goes up by $50 billion. For markets, this is the issue of a point of no return, which some sovereign issuers like Italy experienced in 2011. Yields on “BTPs” went to 7.2 percent until the ECB had to step in with liquidity support and bond protection programs (OMT).
If yields do breach the 5% to 5.5% zone, which could add another $100 billion, the prospect of 6% to 7% becomes more accurate, causing the debt costs to spiral. The Fed would have to repeat the March 2020 playbook of purchasing $1 to $2 trillion of Treasuries to stabilize the debt.
Figure 3: Debt costs ($, trillion) and forward yields
Source: Bloomberg
For now, tariffs have negative connotations regarding headlines because of their unknown economic impact on inflation and the trading partner’s retaliation. However, investors may see this as a ‘positive’ to what Trump said in yesterday’s presser:” Over the next four years, the United States will take off like a rocket ship. But really, it’s already doing it.”
The pre-market shows tariff-sensitive sectors such as consumer discretionary, staples, and materials are up, as are tariff beneficiaries like industrials, as the dollar index retakes 109. Treasury yields discount the risk of overheating with increasing fiscal stresses.