Tax cuts boost growth sentiment and rate forecasts but fiscal deficit a concern: Quarterly fixed income and currency ...
- New Federal Reserve (Fed) chair Jerome Powell will take his position in February
- Tax cuts provide a boost to growth prospects
- We raise our forecast for the federal funds rate, expecting four interest rate hikes over the year
The US yield curve flattened over the quarter, as yields of shorter-maturity bonds rose, but 30-year yields fell. The Fed raised interest rates by 25bp as expected in December, taking its target range to 1.25% to 1.50%. Minutes from the Federal Open Market Committee meeting stated that a “couple of members expressed concern about whether inflation would return to 2 percent on a sustained basis in the medium term.” On the other side of the argument, the minutes also noted that “a couple of participants expressed concern that the persistence of highly accommodative financial conditions could, over time, pose risks to financial stability.” The economy continues to perform well, nonfarm payroll data for November showed a gain of 228,000 and the unemployment rate remained at 4.1%, an 18-year low.
At the end of 2017 the Senate approved the final version of President Trump’s tax bill, the most significant reform to the US tax system for decades. This reduces the corporate tax rate from 35% to 21% and simplifies individual taxes, lowering tax rates for most income brackets. A number of major US companies reacted to the news by announcing special employee bonuses. This has caused a number of forecasters to increase their expectations for growth in both 2018 and 2019.
The stronger domestic outlook, combined with a broad-based global upswing, should underpin a continued normalization of US interest rates through the year. Financial conditions have actually eased in the US due to significant equity market gains, with the Goldman Sachs Financial Conditions Index now showing the easiest conditions since 2000. As a result, and assuming that financial conditions don’t unexpectedly tighten as a result of equity market weakness or a larger-than-expected rise in longermaturity bond yields, we now expect the Fed to raise rates four times in 2018, most likely once per quarter.
Jerome Powell will take over as Fed chair in February and is likely to reiterate the message of gradual normalization in interest rates and a reduction in the Fed’s balance sheet. The more robust economic outlook means that the unemployment rate is likely to continue to decline and to fall below 4%. This would support a higher terminal rate for the federal funds rate and raises the risk that the economy will require a faster policy response. One further result of the tax reform is the effect on the fiscal deficit, which is now expected to rise to 3% to 3.5% of GDP in 2018 and 4% to 4.5% of GDP in 2019. This should weigh on longer maturities over time and temper any further yield-curve flattening.
Isobel Lee
Head of Global Fixed
Income Bonds
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