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- Capital allocation in the time of 5% notes
Capital allocation in the time of 5% notes
Gyubin Hwang
October 23, 2023
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GH
Money markets
The expectation hypothesis for the term structure of interest rates holds that the long-term rate is a weighted average of current and expected future short-term interest rates.
Tomasz Wieladek, Chief European Economist at T Rowe Price, highlights the flaws of this hypothesis and posits that the central banks and governments are not immune to supply-demand fundamentals in money markets. (FT)
Put simply, governments are issuing more debt even as central banks are unwinding QE/bond purchases, resulting in private buyers absorbing an ever-increasing bond supply. Yields thus have to rise to attract a more risk-averse pool of buyers.
Today, the 10-year Treasury yield exceeded 5% for the first time since 2007 on the back of “higher for longer” rates and further bond sales.
10-year Treasury Note Yields (TNX)
Slowing this cycle requires governments to 1. spend less and/or 2. increase revenues whilst simultaneously increasing the pool of buyers who will dip into bond markets. Option 1 seems unlikely in the face of a global pursuit of energy and supply chain autarky - at least for those that can afford it - and a race to decarbonise developed economies. What is left? Higher taxation.
Real tax burdens remain at historical highs in many advanced economies, and the macro drivers of fiscal pressures (ageing populations, higher debt & financing, energy trilemma, etc.) are persistent global themes.
Against this backdrop, a likely policy option might be to tax capital gains and wealth (including stock holdings) while providing larger tax-free allowances on government bonds. The fundamental idea, for a country like Japan or UK, would be to redistribute domestic savings and assets into government-led capital allocation rather than the S&P 500. This means expanding, not scrapping, the sovereign debt tax perk where it is available, ensuring that it remains an accessible, attractive investment product.
And what happens if you are an emerging/submerging economy fighting not just global macro environments, but also a changing climate? Lower credit ratings and higher interest paymentsm, according to Klusak et al. The researchers disaggregate the credit risk rating, find that much of it is driven by GDP per capita, and assess that climate may impact ratings within a 10 year horizon.
Global climate-induced sovereign ratings changes in 2100 under the RCP 2.6 scenario (Klusak et al. 2023)
in [the] absence of climate policies (i.e., RCP 8.5 scenario), 59 sovereigns experience downgrades of approximately 0.68 notches by 2030, rising to 81 sovereigns facing a downgrade of 2.18 notches by 2100.
…
The additional costs to sovereign debt – best interpreted as increases in annual interest payments due to climate-induced sovereign downgrades – in our sample is US$ 45–67 billion under RCP 2.6, rising to US$ 135–203 billion under RCP 8.5.
If you know of any good analysis on potential directions for public capital allocation, green investments, and fiscal balancing, please send them my way.
Suggested reading on this topic:
In Search of Safe Havens: The Trust Deficit and Risk-Free Investments (Damoran)
Do Long-Term Interest Rates Overreact to Short-Term Interest Rates? (Mankiw, Summers)
Peak fossil fuel?
OPEC, like the IMF, now expects “higher for longer” oil demand. Despite much ado about the death of gasoline demand, strong diesel and petrochemicals demand have resulted in a recalibration of demand levels.
Bloomberg Opinion columnist David Fickling remains confident in his “peak oil” assessment (BBG), with the important caveat that this is in reference to crude oil production, not liquid oil demand. Biogenic and synthetic hydrocarbons, including aromatics and naphtha, are receiving increasing attention from oil majors as well as chemicals firms. (JM)
This view of the world - in which fossil fuels remain a significant component of the future energy system - seems to be supported by three megadeals announced in the last couple of weeks: Exxon’s acquisition of Pioneer for $60bn (FT), and Eni and Total signing 27-year LNG contract with Qatar (FT, BBG).
Exxon’s output from the Permian field would more than double to 1.3mn barrels of oil equivalent per day. The transaction would transform its oil and gas business by lowering costs and increasing its capacity to rapidly boost production, Exxon added.
His blunt response to an International Energy Agency forecast that demand for fossil fuels will peak before 2030 is: “I don’t think they’re remotely right . ... You can build scenarios, but we live in the real world, and have to allocate capital to meet real world demands.”
As I was writing this, Chevron has announced its acquisition of Hess for $53bn, adding 250kbd and 570mmcfd to Chevron’s portfolio alongside 1.26BBOe of proven reserves. Higher for longer, indeed.