US Treasury (UST) yields have risen 30 basis points (bps) since the start of 2018, across different maturity levels. We have to go back to 2014 for the last time 10-year yields were at these levels (see chart below).
This has led to suggestions, including from veteran bond investor Bill Gross, that a near 30-year bull market in government bonds may be over.
Prior to January’s developments, the UST curve had undergone a significant flattening in Q4 2017. In other words, the difference in yields on bonds of shorter and longer-dated maturities fell, and quite markedly. Two-year yields increased from 1.48% to 1.89% over the final three months of last year.
This would likely reflect higher growth and inflation expectations, and expectations of faster rate hikes, following the US tax reform bill. The US Tax Cuts and Jobs Act 2017 passed in December and economists estimate it could boost US GDP in 2018 by 0.4%-0.8%. It appears markets had been pricing too low a probability of a tax bill and as a result underestimating the trajectory of US interest rates.
The US dollar index, which measures the dollar’s strength against a basket of six other major currencies, lost around 9.1% in 2017. Having seen some stabilisation in the fourth quarter, it has resumed this weakening trend in January 2018.
Recent comments from US officials regarding trade are a likely factor behind this. So too the pick-up in activity outside of the US, and increasing expectations for a tightening in monetary policy in the eurozone and Japan.
The US tax legislation might have been expected to propel the dollar higher. However, as Schroders’ Economics team argues, “tighter monetary policy from the Federal Reserve is not a sufficient condition for a stronger dollar.”
The Economics team has noted previously that currencies tend to move ahead of interest rates as investors adjust their expected returns. Seen in this light, the current US dollar weakness could be viewed as an unwinding of the period of strength seen between 2014-2016.
While the currency no longer trades near the top of its range, as it did 12-months ago, it remains above its long-term average. Other measures such as purchasing power parity (PPP), which compares different currencies against a basket of goods, also suggest that the dollar may continue to weaken.
Past performance is not a guide to future performance and may not be repeated.
Much has been made of the drastic reductions to corporate tax that President Donald Trump signed into law in December last year, particularly the potential positive impact on growth.
Indeed, already-buoyant markets rose further on the news reflecting more optimistic growth assumptions. But research by Penn Wharton University suggests that over the longer-term, the implications of the tax reform may not be as drastic as they first appear.
The existing statutory US corporate tax rate is 35% but due to various deductions, credits and deferrals the current “effective tax rate”, or ETR, is much lower – closer to 23% on average. Trump’s new tax regime takes the statutory corporate rate down to 21%, and with some provisions of his own the ETR falls to just 9% in 2018.
However, as the chart below shows, much of the effect – more than half – is undone within 10 years. By 2027, the ETR doubles in value to 18%, mostly due to these initial provisions expiring.
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.