Morgan Stanley
  • Thoughts on the Market
  • Jan 15, 2021

Rates and FX Markets Eye the U.S. Policy Path

With Matthew Hornbach and Michael Zezas


Michael Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley.

Matt Hornbach: And I'm Matthew Hornbach, Global Head of Macro Strategy at Morgan Stanley.

Zezas: And on this edition of the podcast, we're talking about the political economy, how Democratic Party control the White House and Congress could affect interest rates and FX markets this year. It's Friday, January 15th, at 10 a.m. in New York.

Zezas: So, our policy research is really about solving the last-mile problem for investors when dealing with D.C., connecting policy choices and investment decisions. Why do you think politics and policy has become more influential to the markets that you're covering?

Hornbach: Well, Michael, since the Georgia runoff elections, we have a different outlook on the fiscal policy trajectory of the United States government. And fiscal policy has a very important link to what happens in the interest rate marketplace, as well as what happens in the currency markets. In particular, with fiscal policy often comes U.S. Treasury issuance. And if that issuance that arrives alongside fiscal deficits is not previously expected by the marketplace, you should expect to see reaction in both government bond markets and in currency markets.

Zezas: Yeah, I think if we take this back all the way to 2017, you've seen a very different trajectory for U.S. fiscal policy over the last few years. Typically it's unusual that you would see Congress approving major deficit expansions, but we had one in 2017 and 2018 with the Tax Cuts and Jobs Act. We had another few in response to what happened with the pandemic. And now, importantly, as you mentioned, we think we're poised to get another one this year. So this overall trajectory is important here. I wonder, Matt, to your point obviously there is a link between issuance and levels. How are you thinking about how this dynamic could be expressed in the rates market going forward? What's in the price coming into the year? Are there areas that people should be particularly concerned with?

Hornbach: Yeah, and I think it's also important just to acknowledge that deficits can occur both in a countercyclical and in a procyclical way. Right? I mean, typically, deficits go up when the economy is going into recession and the government is paying out more and more unemployment claims insurance. As you know, our economists have been calling for a V-shaped economic recovery for some time, and they're doubling down on that projection in 2021. And we are also now expecting a larger fiscal deficit. So in that particular scenario, you would expect yields to move up. We're expecting Treasury yields to end 2021 close to 1.5% Percent at the 10-year maturity. And when we came into the year, that forecast was above consensus. I would say, Michael, depending on how you evolve your thinking on the fiscal trajectory from here, we may even have to raise that forecast at some point.

Zezas: So there's a link there between interest rates moving higher and a better outlook for the economy. Sometimes we hear from clients, though, "what about the policy agenda that is pointed towards higher taxes? Doesn't that matter?" what we think is going to happen with taxes is that they probably will go up but not nearly as much as the spending will increase. That is partly a function of what can be agreed upon by all Democratic senators, that most of the spending that they're planning is in consensus with that cohort, but not all of the taxes. Your more traditional Democrats are probably still sort of Keynesian in their economic approach, but both generally agree on the idea that it might be appropriate to have more deficit expansion when the economy is still recovering, when inflation is relatively low and interest rates are relatively low. So I think you've got this kind of mix of politics and economic orthodoxy motivating deficit expansion, even if you're getting some tax increases. So I wonder, but if someone's pointing out to you, Matt, in terms of looking at the rates market, does it make sense that interest rates are going higher even as taxes are going higher, how are you having that discussion and reconciling those two things?

Hornbach: So the first thing the bond market will pay attention to is supply. And if taxes are going up, but not enough to cover the full extent of the spending that will occur, then the deficit number will go up. And that will likely mean, in most cases, higher supply in the U.S. Treasury market. So, the first reaction is for yields to go up. But then, of course, if other markets like the equity market, for example, feels that the tax hikes are going to be detrimental to more medium to long term growth, then you might tend to see longer term interest rates not rise as much as medium to shorter term interest rates.

Zezas: Yeah, I think that's an important point. And we've framed most of this discussion in terms of the impact on the interest rates market. Under your purview is also the foreign exchange markets, how are you think about this from the perspective of the U.S. dollar?

Hornbach: Well, 2020 was a fascinating year for currencies because you had obviously a unique environment in the wake of the pandemic. As a result, the Federal Reserve adopted extraordinarily accommodative monetary policies, both in terms of its rate policy tool, but also in terms of its quantitative easing program. And as a result, nominal interest rates remained quite low and quite stable. Meanwhile, however, the economy was coming out of a very sharp, acute recession. The break-even inflation market, which is the difference between the nominal yield on a 10-year Treasury note and the real yield on a 10-year tips inflation protected security, those yield differentials widened. In other words, the market started to price in a risk of higher inflation in the future as economic activity was picking up. And as a result of real interest rates in the U.S. falling not only by themselves, but certainly also relative to interest rates outside of the United States, that ended up putting a lot of downward pressure on the U.S. dollar. Fast forward to today and we think the situation has changed slightly. For example, today as nominal interest rates are rising in the wake of the Georgia runoff elections in early January, we're seeing nominal interest rates push higher. But we are seeing real interest rates start to move higher as well. So that is a type of environment in which the dollar typically doesn't either appreciate or depreciate significantly. So, from an investment standpoint and a risk reward standpoint, of course, we think the best position for investors to adopt vis a vis the dollar today is a neutral position.

Zezas: Yeah, and all this obviously also interacts with monetary policy. I obviously have my eye on the appointment of Janet Yellen as Treasury secretary, which is a confirmation hearing that’s supposed to start around January 19th. And then, of course, there's been legislative back and forth about some of the Fed facilities that had been enacted earlier this spring when markets were in turmoil. Is there anything else on your radar that's particularly important that people might not be thinking about, that's right in front of their face?

Hornbach: Well, certainly it’s unclear how the Treasury will finance the $900 billion fiscal stimulus package that was passed in December of 2020. You know, do they finance that via the cash balance that the Treasury has on deposit at the Federal Reserve, or do they issue more bonds? It's our view that the Treasury will finance that 900 billion dollar stimulus deal from the cash balance that it has already on deposit at the Federal Reserve. But that presents some uncertainty around financing in 2021. The other, you know, the other area of uncertainty with respect to the U.S. Treasury is, how will it finance additional fiscal stimulus from here? Will it raise Treasury coupon sizes? We think the answer is probably yes. But there is another question to ask, which is, will the U.S. Treasury, presumably led by Janet Yellen, have a different approach than the U.S. Treasury, which has been led by Steven Mnuchin? The Steven Mnuchin Treasury focused on increasing coupon sizes in longer maturity U.S. Treasuries, whereas we think the Janet Yellen led Treasury may favor raising coupon sizes more in the intermediate sector of the yield curve as opposed to the long end of the yield curve. So those are those remain question marks with respect to how future deficits will be financed by the US Treasury.

Zezas: Matt, thanks for taking the time to talk.

Hornbach: Great talking with you, Michael.

Zezas: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show. 

As Congress and a new administration ponder new stimulus to navigate the pandemic, what will 2021 look like for FX and government bond markets?

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