The Federal Reserve (Fed) raised its target rate by 0.25% to 1.5% in December, in a decision taken with a majority of 7-2. The median “dot plot” showed an unchanged expectation for three further rate hikes in 2018. Two-year treasury yields continued to climb, by 10 basis points (bps) to 1.78%, while the ten-year yield was more stable, closing the year at 2.40% – a decline of 4 bps over the year. This means that over the
course of last year, the US 2-10 year yield curve has flattened by 74bps to reach 52bps – the flattest level for over ten years. President Trump finally achieved his first major legislative success with the passing of
the Tax Cuts and Jobs Act, which will permanently cut the top rate of corporate income tax from 35% to 21%; temporarily cut personal tax rates; encourage investment with faster depreciation; and incentivise the repatriation of corporate cash balances held offshore. The overall fiscal cost could be $1.5tn over ten years, which could widen the deficit from 3.5% to as much as 4.5-5% in 2019. Given that the Fed is set to return
approximately $250bn of treasury bonds to the market in 2018, the excess supply of bonds could pressure interest rates going forward. Economists are debating the potential boost to investment expenditure from the tax changes. Noting that existing capex depreciation allowances are already generous, and lower headline tax rates will be partially offset by the scrapping of multiple exemptions, the net effect on investment and GDP growth could be quite small. The political impact is quite significant however, as the Republican party now has a positive message to take into the mid-term elections this year. US corporate bond spreads tightened in December from 132bps to 128bps for the BBB index, while the ML US High Yield index spread widened from 361bps to 363bps.

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