Transcript
Speaker: Hello and welcome to the Macro Brief from HSBC Global Investment Research, a weekly look at the issues driving financial markets across the world. I'm your host today, Aline Van Dyne, and coming to you from our New York studio.
Speaker: One of the topics we've discussed the most on the Macro Brief this year is what's next for US interest rates. The other one, of course, being AI. Today, we're focusing on rates again, asking whether the Federal Reserve is about to hike, why US bond yields are hitting multi-year highs, and what it all means for global financial markets.
Speaker: So I'm delighted to welcome three experts based here in New York into the studio. Welcome, Hello. Great here.
Speaker: alistair pinder our global equity strategist ryan wang our u s economist and diraj narula a u s rate strategist welcome guys hi hello great to be here So, Deiraj, let's start with the bond markets because there's quite a lot of headline grabbing moves. U.S. Treasury yields, which of course influence the cost of borrowing money around the world, are on the rise.
Speaker: Tell us what's going on and give us some context of what's changed in recent months. Absolutely, Aline. And certainly, as you say, there's no shortage of superlatives being used to describe this recent rise in bond yields that we've seen. There's also no shortage of narratives being talked about out there in the markets about why they've gotten there, whether that's perhaps structurally higher growth in the U.S., whether that's fiscal concerns, or indeed whether it's entirely driven by the Federal Reserve. We would argue it's mostly the third of those things. It's mostly a clear shift in the outlook for what the Fed may or may not do in the coming meetings in the coming months. And that's a clear shift from where we were earlier this year when everyone's talking about rate cuts. We're now an environment where Chairman Warsh at the Fed has told us maybe the Fed will need to act if inflation doesn't come out down soon enough.
Speaker: So, Dheeraj, I want to get back to you on those treasury yields, but let's bring in Ryan. What is the Fed expected to do? Yeah, well, as D-Raj said, all this year there's been no policy rate moves and we did get 75 base points of rate cuts towards the end of 2025. And I guess the Fed is now asking itself the question, does it need to reverse some of those rate cuts because of how inflation been how long inflation has been? and how long It's been running at an elevated pace. Now, all year long, we've been anticipating that the Fed would not make any change to policy rates this year, neither rate cuts nor rate hikes. And we still retain that as a baseline view.
Speaker: But given how close the debate appears to be at the Fed, we now think that even at the September f FOMC meeting, it will be an extremely close call and probably close to 50-50 essentially whether the Fed might deliver a 25-base point rate hike.
Speaker: So, Dheeraj, back to the bond market, this is obviously a focus. Is there anything else going on? And I thought that yields had fallen slightly after Jackson Hole and various speeches by Fed Chairman Kevin Walsh.
Speaker: Sure. So I think in the aftermath of the Jackson Hole symposium last week, we heard from Chairman Warsh a bit more about how he's thinking about the economic backdrop. He told us he didn't really see policy rates today as restrictive, um but he gave us a lot more clarity on how he's thinking about inflation. And at least for longer term treasury yields, that did reduce some of that what we describe as uncertainty premium in there. So long end yields initially actually came down as markets appreciated some more clarity about the Fed outlook. That said, over the past couple of days in particular, we've seen a renewed pickup in energy prices. We've seen some more headlines around geopolitics. And markets seem to be getting worried about whether inflation may actually cool down enough for the Fed to not have to act on interest rates.
Speaker: And where are we then on U.S. Treasury yields and and our expectations? Yeah. Sure. So the 10-year Treasury yield as we speak is around 4.8%, but we're expecting that to cool off into year-end. We're expecting an end-2026 10-year Treasury yield of 4.65%. So we did revise our forecasts up. We previously had 4.3%, but we do think Treasury markets will still somewhat cool down going into year-end as some of these uncertainties dissipate and as the Fed outlook becomes clearer.
Speaker: Now over to you, Alistair. What does all this mean for global equity markets? I mean, historically, higher bond yields have been negative for equities. They've they've typically raised ah the risk-free rate and that has historically compressed valuations. Though there's a few things which I think are kind of important to differentiate here. First, it's really important what the starting level bond yields were. So like our analysis basically says the lower the bond yields, the more sensitive they are. So when bond yields were in, you know, at 2% back in 2022, every 50 basis points rise was basically an 8% hit to to the 12-month forward PE.
Speaker: Today, given that we're already at very elevated interest rates, that sensitivity has gone down to a 4.5%, 5%. So that's one aspect. So the second thing is, well, what is the the current backdrop?
Speaker: um Because valuations can compress, but what if that's being offset by stronger earnings? And again, where we are in the cycle, going past the Q2 earnings season, the S&P 500 just delivered 50% EPS growth. So 5% valuation here versus 50% EPS growth. Actually, I'm not that worried about the valuation compression here because we've got more supportive things going on. And then the other thing just to highlight is that the S&P 500 and US equities have a lot of fixed rate long term debt. Actually, only 20% of their debt is short term. 10% is floating, you know, 10% is short term. So actually, again, the sensitivity to interest rates is much less. Now, the one area where I could say it could be different this time round is because of this huge AI capex cycle. Of course, yeah.
Speaker: Actually, bizarrely, the hyperscalers, the Magnificent Seven, used to benefit from higher interest rates because there's so much cash that they weren't sure what to do with it. Now they're spending it all to you know build out this capex, they're having to raise new debt. And that becomes a bit more of a challenge at a time where bond yields are rising. So that, I think, is the biggest challenge that equity markets have to face at this point.
Speaker: Ryan, the higher bond yields, what does that mean in terms of the Fed's calculations? Are those already restrictive potentially? Is there less sensitivity like Alistair has just highlighted? How do the two work together?
Speaker: Yeah. Well, I mean it's a very complicated question and and and I think different people have different perspectives on how to answer that question and even you can you can see that judging by what Alistair and D. Raj have said.
Speaker: On the one hand, you could say, well, higher yields might be a sign of confidence in the US economy. It could show that growth is strong. Obviously, the AI investments at the moment are because there's strong demand to make those investments and that could be contributing – not only to GDP growth at least currently, but also I think D. Raj has pointed out probably contributing to some of that backup we've seen in treasury yields.
Speaker: So for the Fed, you know the Fed has the responsibility to control inflation. That's the primary responsibility. So they are very sensitive to what's happening in markets, but they have to disentangle what sort of signal is being sent by those rising bond yields.
Speaker: Yeah, and this entanglement between all of these different signals is a very interesting one. And Treasury markets are clearly feeling a lot of that, both in terms of the short term thinking, but also sort of the long term thinking that I'm sure policymakers are going to have to deal with. Because on the one hand, as Ryan points out, all of this aggregate demand coming from this ai investment is ultimately also one of the things potentially pushing up inflation in the near term. That feeds into the Fed's thinking. At the same time, all of this debt that's coming to the market, there's narratives around whether or not that's competing with treasuries. So clearly high quality, high cash position issuers coming to the market issuing long dated debt. Does that crowd out some of the market's appetite for absorbing treasuries? And does that push up interest rates overall? And then finally, from a longer term perspective, and one of the things we've heard from the Fed themselves, is will ultimately this AI boom and all of these investments translate into productivity gains that maybe could be disinflationary long term? So treasury investors are clearly having to weigh all of these different facets of how these AI fiscal debt factors are playing into each other. And it's certainly not going to be a simple answer in the near term.
Speaker: Let's take a quick break and we'll be back with more from our New York team in a moment to discuss deficits and borrowing.
Speaker: And we're back. We've been talking about what to expect in the US in terms of interest rates, really complicated picture. Let's talk a bit more about the deficits and the borrowing. Alistair, how are any of these concerns playing out or or not in the equity markets?
Speaker: um I mean, on the the deficit side, I don't think it's the the biggest point of focus, at least for for the US right now. i mean, the way it's really translating into equities is through, you know, the bond deals, as we've discussed. I think from a global picture, I think the one thing that concerns me a little bit with all this attention on on the US deficits and the bond deals, you know, responding to that.
Speaker: um I do worry that this then translates into a global question about deficits. And of course, one of the areas that has historically been quite sensitive to that is emerging markets, where, you know, you have countries in LATAM, countries in EMEA, countries in ASEAN.
Speaker: or with high deficits or with high debt to GDP? And this has become a global, ah you know, frame of of worry. and And again, does that, you know, make some of these countries that have been performing quite well actually start to come under bit of pressure?
Speaker: Ryan, from your perspective, what about the US deficit and the fiscal pressures? They're obviously in focus in the markets, but are there any catalysts to look out for?
Speaker: Well, I think if you look at the actual data on budget deficits in the United States, federal government budget deficits, they clearly have remained elevated roughly at around $2 trillion dollars per year and that equates to over 6 percent of nominal US GDP. and By all it indications, will probably be looking at the same sort of magnitude of deficit over the next 12 months just as it was over the previous 12 months.
Speaker: Now, in terms of catalysts and deadlines, there are going to be some next year. One deadline is going to be the US's need to raise the so-called debt limit. ah The debt limit is currently far less than $2 trillion dollars away. So under current borrowing trends and current deficit trends, clearly that will be something that needs to be done.
Speaker: And then a little bit further down the road, ah the US will also have to deal with expiring tax provisions related to the One Big Beautiful Bill Act. I mean even into next year, you could say this is a type of fiscal issue because the fiscal impulse that we had this year from lower taxes will in a sense fade a bit into next year and then basically the year after that, the policymakers will have to make renewed decisions.
Speaker: And of course, we've talked before about the impact of the U.S. midterm elections in November and the potential for a shift in the control of Congress and and how that plays out with these deficit issues, because you will need bipartisan buy-in to resolve any of them.
Speaker: Yeah, well, I mean I've taken a broad view of what the midterms and the possible outcomes might mean in terms of the fiscal situation and if you look at current betting markets, they are anticipating that democrats will take control of at least the House of Representatives or at least they're pricing in an over 80 percent likelihood of that outcome. and In that situation, I do think those deadlines I mentioned over the next two years will have to be resolved on a bipartisan basis. There's still another scenario where Republicans do hold on to that both the House of Representatives and the Senate and then the backdrop could be a little bit different because Republicans would still be able to rely on a me on a mechanism known as budget reconciliation. and In that scenario, it seems more likely that fiscal debates would be within the Republican Party rather than ah between Republicans and Democrats.
Speaker: Dheeraj, does this all seem quite far away in terms of the bond markets and what's driving them at the moment? Or what are some of the catalysts from your perspective? Sure. So I think fiscal narratives come and go in the Treasury market pretty much every year. And we see when sort of these narratives line up, the Treasury market can get a little bit worried. And typically you would see, especially at the long end of the Treasury curve, of interest rates feel the pressure.
Speaker: One of the things that the Treasury has done over the past couple of years in terms of dealing with kind of these deficit concerns is keep all of its incremental issuance, all of its additional supply at the very front end. So it's been supplying a lot more T-bills. It's not been increasing the supply of 10-year Treasuries, 30-year Treasuries. And actually, one of the things the Treasury Secretary announced a couple of weeks ago was that the Treasury would raise the size of its buyback. So would actually buy back more long-dated debt funded with front-end or short-dated Treasury debt.
Speaker: We don't think that that's ah ultimately a resolution to these deficit pressures of these fiscal worries. It's simply transforming the maturity profile of outstanding treasury debt. A type of twist operation. A type of twist operation, exactly, that can make investors a little bit less concerned in the sense that long-end treasuries have a lot more risk. They're a lot more sensitive to swings in interest rates. But overall, the magnitude of these buybacks and especially the overall level, as Ryan pointed out, if these deficits in debt stock – The buybacks are drop in the bucket at that scale. And so we don't think this resolves the underlying fiscal pressures. It maybe provides a little bit of a liquidity boost short term, but we've seen the market shift very quickly away from any reaction it had to the buyback announcement.
Speaker: Brian, I know you're also looking for some data in the next few weeks. So let's bring it back to what we're expecting in the near future. Yeah, absolutely. So you know for the Fed, it often comes down to the dual mandate and the dual mandate basically relates to maximum employment and inflation. And so it's no surprise that the financial markets often focus in on the jobs data and the inflation data.
Speaker: On the inflation side, and that's top of mind right now because by many labor market indicators, the labor market is in a broad type of balance. So it's getting a little bit less attention right now. But on the inflation side, we will have the August CPI coming pretty soon.
Speaker: And then towards the end of September, we will have August PCE inflation data. Now, the interesting thing about that is one part comes before the September f FOMC meeting, the CPI, and then the PCE numbers will come in late September after the September f FOMC meeting. And then something else that we flagged and that is now upon us is that at the end of September, that September 30th, PCE inflation release will include some methodological revisions, which likely will reduce measured inflation by tens of basis points, a few tenths of a percentage point.
Speaker: And on the one hand, that will just be a technical adjustment. But on the other hand, it will impact essentially the Fed's ah inflation measure, the 2 percent inflation that the Fed is looking for is on a PCE basis.
Speaker: I think, you know, it's just interesting from an equity perspective. You talk about the data, and a huge number of catalysts now between September and early November, the midterms, as we discussed in in early November, the inflation prints, the Fed meetings. And then also, you know, it's been reported by Reuters that after Labor Day, Anthropic will be producing their S1. This is the first time that we'll really get to assess kind of like the balance sheet and and the the income statement for what will be arguably one of the biggest AI companies in the US. And so it feels like this is going to be a key driver for the monetization team. But we're in this, you know window, I think, of two months where a huge amount of information is going to be absorbed by the market. And I think it's gonna quite choppy and volatile.
Speaker: On that note, let's get back into the studio to discuss what happens next after we have some more information. So thank you. Thank you. Thank you. So that was Deeraj Narula, Alistair Pinder and Ryan Wang on high US interest rates and global market implications.
Speaker: Please like and follow the Macro Brief on your podcast platform. And while you're there, check out our Asia Focus sister podcast, Under the Banyan Tree. This episode was hosted by me, Aline Van Dyne in our New York studio and produced by Graham Mackay.
Speaker: Thanks for listening and we'll be back again next week.
