by Bryan Perry
October 29, 2024
The current backdrop for interest rates and bond yields is dramatically different than it was just six weeks ago. On September 18th, the Federal Reserve slashed the Fed funds rate by 50 basis points in response to the data at that time, mostly pointing to a not-so-soft landing within the labor market, plus rapidly deteriorating economic data from China, Germany and Canada. This slowdown prompted Beijing to launch an extensive stimulus plan, while the European Union cut rates by a quarter point on October 17th for their third cut since June, and the Bank of Canada cut rates on October 23 by 50 basis points to 3.75%.
Outside the U.S., these serious growth concerns continue, while the U.S. economy has proven more resilient, probably because ours is weighted heavily on services versus manufacturing. The service economy makes up about 79% of U.S. GDP, so as long as the labor market remains resilient during periods of slower hiring, a 2% to 4% growth rate can be maintained with inflation trending lower.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Around the globe, other key economies that depend more on exports, such as Mexico, Australia, Brazil, and many Asian countries, are seeing some gradual slowing of manufacturing activity, while India is experiencing the world’s most rapid GDP growth of 8.2%, supported by a buoyant manufacturing sector that grew by 9.9% during the 2023-2024 period. It makes sense that more global companies are moving more of their manufacturing operations to India, especially in the consumer electronics sector.
One can argue that these conditions, coupled with companies spending vast amounts on investment capital in the race to automate via AI, is helping a great deal to keep the U.S. economy on a relatively sound footing, but if those developed economies among our largest trading partners are experiencing subdued growth, then it stands to reason there will be a drag on the U.S. economy at some point.
With that said, the bond market is now convinced that the Fed will dial back its tightening of monetary policy – with the stock market taking this message as one of future sales and earnings prosperity that has yet to be priced into stocks. Hence, the rally for the S&P to hit 6,000 by year-end looks to be on course to finish the year with a nearly 25% gain, even as the Fed Funds rate sits at 4.75%-5.00%, with the average 30-year mortgage sitting at 6.6%, and prices for most food, shelter and services remaining way up.
According to the U.S. Bureau of Labor Statistics, the Consumer Price Index (CPI), which measures the average change in prices paid by consumers for goods and services, has risen 20% from 2020 to 2024.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Aside from tens of millions of Americans finding it super challenging to manage the cost of living, one of the biggest drags this inflation surge has had on America is the soaring federal deficit, now growing at a rate of 8% year-over-year. True to form, the federal government has spent $1.83 trillion more than it has collected in fiscal year 2024, which ended on September 30. This deficit is $138 billion larger than the previous fiscal year, and there has been very little discussion on the Presidential or Congressional campaign trail to slash deficit spending and address a national debt that is fast approaching $36 trillion.
One can strongly argue that in order to maintain this secular bull market, fiscal policy on Capitol Hill will have to change, and it will likely only change in a bipartisan manner if we see both spending cuts and higher taxes. Outside of this arrangement, little, if any, structurally positive spending and tax policy will emerge from the next administration. Otherwise, Congress risks blowing a hole through the debt ceiling.
When those changes come, the allure of owning investment grade tax-free bonds will likely attract investors like bees to honey. The government already derives nearly half of its revenue from taxing people’s income. In fiscal year 2023, individual tax returns accounted for 49% of the total federal revenue. And the top 1% of earners paid nearly 46% of all income taxes in the most recent tax year.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
If taxes must increase to address an ongoing and rising revenue shortfall, then those taxpayers in the higher brackets might want to consider loading up on investment-grade tax-free bonds at today’s prices, before the Fed cuts rates even further and the IRS starts looking to take more of your pre-tax income.
There are several ways to purchase tax free bonds – individually, through closed-end funds, mutual funds, or ETFs. As the Fed continues to reduce rates and Congress is forced to raise taxes to stave off a federal debt meltdown, tax-free municipal bonds will flourish in price and demand. There is no doubt that this fiscal white-knuckle ride is coming down the track. We may as well be ready when it gets hot and heavy.
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