Fixed Interest

The process I follow begins with reviewing the outlook from the International Monetary Fund (IMF), then I run my models, and currently, I'm at the beginning of that process. I thought I'd share the IMF's base case outlook and where I might adjust it based on my models.  I believe these nuances are important.

What is immediately clear when you examine the complete outlook is that there is no recession on the horizon. The US is experiencing growth at 2.2%.

Following a difficult period in the Euro area, despite a miserable past, recovery is underway with modest growth expected at 1.1% in 2024 and 1.6% in 2025. As for China, the IMF estimates growth at 4.8% this year, but I think it will be closer to 4.6%, with a slight recovery to 4.5% next year. However, I think 4.3% is more likely next year, primarily due to ongoing weak demand in the Chinese economy. That said, these are still excellent figures, especially considering the size of the Chinese economy, which is growing at a pace four times faster than Germany’s and nearly twice as fast as the US.

The standout performer in recent years has been India. It grew by 8.2% last year and 7% this year, with projections ranging from 6.5% to 7% next year. India's high growth is set to continue for the next two decades, driven by a rising working-age population. This is unlike China, where the working age population is shrinking.

In Australia, growth has been relatively soft this year, hovering around 1.2%, largely due to the decline from a record high commodities boom. The IMF forecasts 2.1% growth next year, but I think it will be closer to 2.5%. Still, this is modest growth compared to Australia's historical standards. On the inflation front, most places are experiencing low and falling inflation, except for Australia. The US's headline CPI is projected to decrease from 2.3% this year to 2% in 2025. The Euro Area is also seeing a slight reduction, from 2.4% this year to 2.2% next year. In China, inflation is low, with deflation last year and a forecast of around 0.9% to 1% this year, due to weak consumer demand. Usually, inflation in China is about 2%, and it should gradually increase as the economy recovers.

In India, inflation is targeted at 4%, and they are on track to meet that goal this year and next. In Australia, inflation this year could be around 2.7%, slightly lower than the 3% the IMF expects, with a slight increase to around 3.7% next year.

Overall, what we see is that the global economy is returning to reasonable growth. The fear of a recession has subsided, and the outlook is positive across most regions. Growth in the US is likely to exceed the Federal Reserve's estimate of 2%, with some models forecasting around 2.2%.

Thanks to the recovery in the Euro Area, India's strong performance, and Australia's rebound, the global outlook remains strong.

Still, it is possible that the market has already priced this in.

Last week, during a press conference following the Federal Reserve's decision to cut rates by 25 basis points, something we had forecast, J. Powell was asked about the US government debt. He stated that while the current level of US government debt is sustainable, the trajectory of that debt is not. This comment has sparked a discussion on how the Trump presidency, with its emphasis on cutting corporate taxes, will impact the US budget deficit.

Looking ahead, the US budget deficit for 2026 will be drafted in 2025 when both the presidency and Congress — the Senate and the House of Representatives — are all under Republican control. Interestingly, the Speaker of the House, Mike Johnson, who is part of the conservative Freedom Caucus, has made it clear that he wants to reduce the size of the US budget deficit. This will be a key issue moving forward.

The US budget deficit has been a frequent topic of conversation because it can serve as an indicator of trends in the commodity cycle. For instance, the most recent low in the deficit occurred in 2022, at 3.9% of GDP, signalling the bottom of the cycle for commodities. However, the budget deficit rose to 7.6% of GDP in 2023, and for the current year, it is expected to peak at 7.63% of GDP. This suggests that the peak in commodity prices may occur around 2026.

A significant part of the discussion centres on President Trump's promise to reduce US corporate tax rates to 15%. This is the same corporate tax rate as Germany. The potential cost of this tax cut is substantial, with estimates ranging from $460 billion to $673 billion. For the sake of discussion, if we assume the cost is around $500 billion, the impact on the US budget deficit will be significant. Currently, the US deficit is estimated to be $2.2 trillion, or 7.3% of GDP, and projections for next year remain the same.

Sustainability in terms of the US budget deficit is generally considered to be a level that matches GDP growth. Given that US GDP growth is expected to be around 2%, the deficit could realistically be about $600 billion, much lower than the current $2.2 trillion. This creates a significant challenge for policymakers, especially since cutting spending will likely be the key to reducing the deficit.

Mike Johnson, as part of the Freedom Caucus, will push for cuts in government spending, and President Trump has appointed Elon Musk to assist in finding opportunities to streamline government expenses. Musk, who is known for his ability to cut costs in companies like Tesla and X (formerly Twitter), will look for inefficiencies in government spending, even though the "Department of Government Efficiency" he is heading will exist only as an advisory body. Nevertheless, Musk’s skill and reputation for cost-cutting could play a crucial role in helping to bring down the deficit.

The push to reduce the budget deficit while implementing tax cuts will be a central focus in the lead-up to the 2026 US budget. The proposed corporate tax cuts to 15% will add roughly $500 billion to the deficit, but they are expected to increase after-tax corporate earnings, which should drive stock prices higher. This contrasts with the Democrats' proposal to increase corporate taxes, which would likely lead to a sell-off in the stock market and a potential recession in the following year.

If the Republican-led government can successfully reduce the budget deficit while implementing corporate tax cuts, it could be a significant boost to both the US economy and the stock market in 2026.

Well, I’ve spoken before about the Reserve Bank of Australia and the Federal Reserve. The easiest way to understand what central banks are doing is to look at employment growth. When employment growth is higher than the long-term median, central banks tend to either hold rates where they are or to tighten. When employment growth is lower than the long-term median, central banks tend to cut rates.

So, today we’ll look at where things are and explain what’s been happening this week and why the Reserve Bank of Australia held rates where they were, and why the Fed cut rates by 25 basis points. In the first slide, what you see is the rate of growth of employment in Australia. The long-term median is 2.3%, but the current rate of employment growth is 2.97%. So, it’s above the long-term median, and that’s strong. This is largely due to support from the federal government employing people in the public sector. But as the Deputy Governor of the Reserve Bank says, these are still real jobs. For that reason, the RBA is holding rates steady until inflation falls or unemployment rises. This means that if unemployment rises, we can expect inflation to fall in the future.

The Federal Reserve, on the other hand, has a different story. When we look at the rate of growth of employment in the US, the level of actual employment year-on-year is 1.3%. Employment growth has been slowing as we go through the year, and that’s lower than the long-term median of 1.6%. At the previous meeting, the Fed cut by 50 basis points. I had forecast at that time that it would continue cutting rates in November and December, and we just saw a 25 basis point cut today. At the Fed Reserve press conference after the Fed statement was released, Jay Powell said that geopolitical risks to the US economy are elevated. Still, he said that when we look at the US economy, it is still very sound, with strong growth, a strong labour market, and inflation coming down.

When he was asked about the US national debt, Powell said the national debt is not unsustainable, but the path of the growth of that debt is. In other words, the size of the US deficit is too large.   If the growth in US Debt continues, Powell warned, it will ultimately be a threat to the economy.

Since the election of Donald Trump, we’ve seen that there is a significant number of supporters in the House of Representatives of proposals to cut spending. Also, suggestions for cuts could come from figures like Elon Musk, while Robert F. Kennedy Jr. has advocated closing whole sections of the Food and Drug Administration. These budgetary savings could help reduce the size of the budget deficit, but we’ll have to wait and see how it plays out.

Powell currently holds his appointment until May 2026.  He was asked twice during the press conference whether he would resign. He replied with a simple "no" when asked if he would resign if President Trump asked him to resign. When asked again if he or other board members could be fired by the President, he said, "No, it is not permitted by law." So, unless Powell is impeached by both houses of Congress—which is incredibly unlikely—he will certainly serve his term through 2026.

When a reporter asked Powell about the neutral rate, or the natural rate of interest, he said that it’s difficult to pinpoint. The natural rate was defined in the 19th century by Swedish economist Knut Wicksell. Powell acknowledged that we’ll eventually know the neutral rate “by its works”. Based on our models, we believe the neutral Fed funds rate is 3.85% right now, considering where US employment, inflation, and inflation expectations stand in the US. We think the Fed funds rate will continue to fall until it reaches that level of 3.85%.

As I predicted, the Fed cut rates by 25 basis points in November, bringing the effective funds rate down to 4.6%. We believe there will be another rate cut in December, bringing the effective Fed funds rate to 4.35%, which will be equal to the Australian cash rate.

We don’t think rates will stop there. We expect another rate cut on January 28th, bringing the Fed funds rate to 4.1%. Following that, there will be a Fed meeting on Saint Patrick’s Day, where we expect another rate cut, bringing the Fed Funds rate to 3.85% This is where our model suggests the neutral Fed funds rate should be.

Any changes to that forecast will depend on the direction of inflation, unemployment, and inflation expectations in the US. If inflation goes down, unemployment rises, or inflation expectations decrease, rates could be cut further.

Still for now, we think the bottom of the Fed funds rate will be 3.85% by March next year.

Interestingly, the Fed is not just cutting rates; it’s also doing quantitative tightening at a rate of $25 billion per month. That means the size of the Fed’s balance sheet is falling by $25 billion each month.

However, at that rate, it will take nearly 10 years for the Fed’s balance sheet to fall back to the $4 trillion it was at in 2019. So, while the Fed may continue cutting rates next year, quantitative tightening is likely to continue for many years to come.