Continued American Exceptionalism Validated by Global Bond Spreads

The political narrative has been dominated by an assertion that US tariff increases, and aggressive foreign policy actions have caused a loss of confidence in the US, resulting in global central banks selling US treasury securities, which could put the US at risk of losing its status as the global reserve currency.  The advantage of economic discussions vs. political assertions is that there is actual data to test the assertions.  The reality is that US bond spreads have tightened dramatically over the last year with the average spread of US treasuries relative to our top 17 trading partners shrinking by an average of 51 basis points. 

The main implication of this tightening is not related to US exceptionalism but rather an indication that the rest of the world is way ahead of our incompetent Federal Reserve and have reduced their policy rates to the neutral rate over a year ago, resulting in stronger economic growth and increasing the probability that the next policy move might be an increase.  Japan is the most extreme example of this hawkish move among non-US central banks, where long term spreads of US treasuries over Japanese bond yields have tightened by 136 basis points.  There has also been a policy shift in many nations to increase government spending on defense and other areas, particularly in Germany where spreads of US treasuries over Bunds have tightened by 69 basis points over the last year.

The economic implication of this tightening is that the primary driver of long-term bond rates is not global bond prices or small changes in fiscal deficits but rather expectations of future central bank policy.  In the US, 10-year treasuries have traded consistently 100 basis points over the expected terminal rate of Fed Funds.  10-year treasuries are currently at 4.22 and the expected terminal rate is 322 resulting in an exact spread of 100 over, which is in line with the 25-year spread of the 10-year over the Federal Funds rate (see chart below).

Most investors are implicit Keynesians and believe that strong economic growth causes inflation.  Consequently, recent reports of strong US economic growth with 3^rd Quarter GDP growth rising to 4.4% and 4^th Quarter GDP Now from the Atlanta Fed running at 5.4% have caused inflationary expectations to rise from 2.30% to 2.47% over the last two weeks and causing the terminal rate of Fed funds to rise substantially.  The Monetarist theory of inflation states that excessive money supply growth caused inflation which was proven with the money supply growing by 60% and nominal GDP growing by 38% resulting in inflation increasing by 22%.  Keynesians incorrectly predicted that inflation was transitory as their flawed models indicated that unemployment would keep inflation contained.  It is true that excessive GDP growth caused by excessive monetary growth as happened in the late 90s, will result in inflation, so it is important to distinguish between normal economic growth and money supply expansion fueled growth.

We continue to project that US inflation drops substantially over this year to the Fed’s arbitrary 2% target on PCE (see chart below).  The primary driver of the expected decline is the gradual decline in the two-year delayed shelter component of CPI to reflect the real time decrease in market rates.  Moreover, the primary driver of inflation is the money supply, and the monetary base has dropped by 6% over the last year indicating that we are headed to actual deflation.  Finally, oil prices can be a factor in driving inflation but are down over 15% over the last twelve months. If inflation declines to 2%, we are very likely to have 3 Fed rate cuts to 2.75% resulting in a 3.75% 10-year treasury rate.  This decline in long term rates will support our estimate of the PE ratio of the S&P 500 Index remaining at 23x which will cause the S&P end 2026 at 8,000.