Given how it dominates Australian political economic debate, it is perfectly apt that the biggest impact of the election of Donald Trump is on interest rates. But whether his impact will be real rather than just a change in market expectations remains to be seen.
Predicting interest rates can make mugs of both commentators and investors.
Prior to the US presidential election, the market was predicting a one in three chance of a cut in the cash rate to 1.25% by August next year; now there is around a two in three chance of a rise to 1.75%:
Nothing about Australia’s economic conditions has changed. Yes, commodity prices have improved a bit, but they have also been quite volatile. There’s no suggestion of the economy firing up – indeed some economists suggest it has slowed and that growth for 2017 will be closer to 2% than 3%.
So why the change?
For all the very real concerns about corruption in a Trump presidency, it’s tougher to get a forecast on what impact he will have on the economy.
Trump’s two main economic policies are for large tax cuts – both for companies and for high income earners – and for a $1tn infrastructure spend.
Both of these plans would increase the size of the US budget deficit and are thus, in a pretty standard Keynesian economic sense, expansionary.
It’s not a great surprise that this week the OECD suggested that these plans mean that economic growth in the USA “is set to strengthen in 2017 and 2018” due to the “assumed fiscal stimulus boosts” to the economy.
The biggest short-term impact of such a plan is that it would increase inflation, and this was reflected immediately in the increase in the US treasury 10-year bond yields, which rose once it became clear Trump had both won, and was able to deliver a victory speech that didn’t suggest he was about to institute a military dictatorship:
The increase in bond yields reflects investors’ belief that inflation will increase in the mid-long term and thus they are seeking a higher rate of return. And because Australia’s bond yields largely follow the lead of the USA’s, Australia’s bond yields also rose.
And the implications of this are clear – the cost for the Australian government to borrow money has increased quite markedly in the past month.
Back on 24 August, when bond rates were at their lowest, the government borrowed $1bn for 11 years at a rate of 1.9459%. By 21 September, when it borrowed $900m for 11 years it had to pay an interest rate of 2.1936% – still historically low.
By 2 November, when Hillary Clinton was still heavily favoured to win the election, the government borrowed $1bn for 11 years at a rate of 2.4189%.
The Trump victory saw a sharp rise in the rate the government had to pay. On 11 November it borrowed another $1bn this time for 12 years, but now at a rate of 2.7005%, and last week when it borrowed $900m for 12 years the rate was up to 2.8136%.
Now we shouldn’t get too excited. Bond yields remain at a historically low level:
But the change does have implications for the budget deficit (the budget estimates $16.6bn will be spent on government debt interest payments) and also for home owners’ mortgage payments.
Government bond yields are often good indicators of where the cash rate will head:
The problem is all of this largely has nothing to do with Australia, where there has not been any big increase in inflation expectations.
A good quick and dirty measure of inflation expectations is to look at the difference between the 10-year bond yields and the inflation-indexed bond yields.
While the difference has increased since the middle of the year – indicating an increase in the expectations for inflation since then – there has actually been little change since Trump’s victory:
It would appear the drive for higher interest rates is thus all via events in the USA, rather than anything to do with our economy.
And the problem is right now everyone is just guessing about what will happen under a Trump presidency.
Yes, he might instigate a $1tn infrastructure spend. But a close look at what he is proposing suggests the spend will be more about tax breaks for companies on projects which are considered profitable and likely to go ahead regardless than it is for investing in works that would create jobs or improve crucial infrastructure such as water systems, rural bridges and roads.
And while spending $1tn on infrastructure – no matter how poorly targeted that spend may be – should provide some stimulus to the economy, it is unclear how the Republican party-led Congress will react.
While they appear suddenly less concerned about government debt than they were prior to election day, it would not be surprising if the money spent on Trump’s big vote-grabbing $1tn infrastructure resulted in cutbacks in government services elsewhere.
Thus the impact of the infrastructure spend might not be as inflationary as is currently being expected because it is both poorly targeted, geared more towards company profits than economic activity and offset by reduced spending elsewhere.
So while right now, due mostly to the unexpected election result, the market is predicting big changes to the USA’s economy, there has undoubtedly been a bit of an over-reaction.
While for now it appears the impact is to signal the end of interest rate cuts in Australia, we should always remember the market can get it wrong.
Twelve months ago the market was barely even expecting a rate of 1.75% let alone the current rate of 1.5%: