The Trump growth rally that began with his election success appeared to run out of steam in late December 2016. Real bond yields in the US, represented by the yield on a 10 year inflation-linked Treasury Bond reached a recent peak on about the 19 December. These real yields reflect the real cost of capital- the risk free required rate of return to which a premium must be added to compensate for investing in any asset or project with more risk to the expected return. Real rates have been exceptionally low in recent times as world-wide demand for capital to invest in extra capacity shrunk away and as global savings rose. The Trump-inspired increase in real rates portended faster economic growth in the US and the extra demands for capital that can be expected to accompany faster growth.
As may be seen in the figure below, real US rates for 10 year bonds have declined from 0.7% to the current 0.4% yield. This is still significantly higher than the negative real rates investors were accepting in early October. Thus the growth outlook for the US can be assumed to be more promising than it was in October but perhaps not as promising as it appeared in mid-December.
The Trump administration has to deliver on its promises to deregulate and lower taxes and also to bring jobs home. These are prospects that have received particular favour from small business in the US, whose confidence levels have reached record highs, as well as from the customers of the leading banks that apparently are now willing to borrow more. This was noted by bank CEOs reporting earnings on Friday – accompanying generally more favourable operating conditions.
It is this additional confidence of households and business that will influence their willingness to spend and borrow more. Balance sheets of US households have greatly strengthened in recent years, with more saved and more equity in their homes, while lower interest rates have reduced their interest expenses; similarly for business borrowers. It is not balance sheets that will stand in their way of increased spending, but the relative lack of confidence in income prospects.
It will also be of interest to note just how consistent has been the recent behaviour of the gold price in response to real interest rates. Real interest rates represent the opportunity cost of holding gold. The more expensive it is to own gold, the lower its price.
The difference between the lower yield on an inflation-linked bond and that of its vanilla equivalent bond of similar duration (that offers a higher running yield), represents the compensation to investors for taking on the risk that in inflation will prove higher than expected. By doing so it drive up interest rates to compensate for the now more inflation expected. In doing so it reduces the value of the conventional bond. In the figure below we show these recent yield differences, representing inflation expected, over the next 10 years in the US and SA bond markets. Inflation expected in the US has risen consistently before and after the Trump election to about 2% per annum. Real yields in the US have reversed course in the US recently. Inflation expected has continued to increase. The US Fed regards 2% inflation as one of its objectives for monetary policy.
The Trump election raised inflation expectations in SA to over 7%. Very recently, as the Trump rally faded, inflation expected in SA over the next 10 years, as revealed in the RSA bond market, has receded sharply to below 6.5%. This must be regarded as helpful for the SA economy. The Reserve Bank has a highly exaggerated view of the influence of inflation expectations on inflation itself. This retreat in inflation expectations as well as a much improved outlook for inflation itself may encourage the Reserve Bank to reverse the course of short term interest rates – an essential requirement if growth in SA is to pick up momentum.
The improved outlook for inflation in SA is also reflected in the declining SA risk premium, the difference in yields offered by a RSA 10 year bond and a 10 year US Treasury bond. This spread in 2017 has narrowed sharply, indicating that the rand is now expected to depreciate against the US dollar at a slower rate, close to 6.4% p.a. and thus consistent with less inflation priced into the bond market.
This better news about the outlook for the rand and so inflation in SA has come naturally enough with a stronger rand. The figure below indicates the trade weighted exchange rate since September. After initially weakening in response to the Trump election, the rand has benefitted from a strong recovery of about 7% since November. Clearly the extra growth and higher US interest rates associated with a Trump administration have neither raised long term rates in SA nor weakened the rand. Indeed the opposite has happened. This should encourage the Reserve Bank to focus on the downside risks to economic growth in SA rather than the upside risks to inflation. These surely have declined, both with the stronger rand and the prospects of lower food prices. The case for lower interest rates in SA has strengthened with the Trump election so that SA too can look forward to faster growth.
