Dagmara Fijalkowski: How might geopolitical tensions and fiscal deficits affect government bonds and monetary policy in the coming year?

Let's start with the outlook. without making any assumptions, we expect mid-single digit returns for holders of government bonds over the next year, simply from yields. Better for portfolios holding some credit, and of course, better still if economy were to turn down. Even if we don't wish for this to happen.

 inflation will likely continue to moderate, at a slower pace, which combined with looser labor markets, will allow central banks to start easing monetary policy in the second half of the year, cutting by at least a hundred basis points over the next year.

That's assuming no recession and more if recession were to occur. The risks to this outlook come from geopolitics and to some extent, labor markets. Geopolitics, because as attacks on oil tankers in the Red Sea continue and we deal with continued war rage waged by Russia, this may at some point lead to higher oil prices. As for labor markets, we are a bit more sanguine about the impact on inflation, believing that its higher inflation will leads to wage demands and not vice versa.

I would like to end with a few words on U.S. exceptionalism in the context of a strong economic growth that we have seen in the U.S. Well, it is not so exceptional when you fuel it with deficits of 7% of GDP. What is exceptional is that these deficits were allowed to happen during the economy that’s booming with no recession.

Yet the spending is unlikely to be pulled back in the election year. Theoretically, fiscal concerns could exacerbate the sale of driving term premia higher, but that would be offset, we believe, by a drop in neutral real rates or r-star, because the stock of debt is likely to weigh on the potential economic growth, as more and more revenues will be diverted to servicing debt from discretionary spending. These are longer term concerns and unlikely to be addressed this year.

Dan Mitchell: What factors are contributing to the stability of developed market currencies?

For the most part, developed market currencies have been very stable this year.

We look at the euro by way of example. It's the most important currency pair in the world, both by trading volume and by influence. And that exchange rate has remained stuck really in a 107 to 110 trading range for most of this year. That's an exceptionally tight range, highly unusual for a currency that would normally fluctuate a lot more.

And we think that the low volatility is really a function of synchronous central bank policy, even though the Fed's interest rate cuts have been pushed back this year and aren't expected to materialize really till June, we've seen similar delays both from the Bank of Canada and the European Central Bank. Ultimately, short term interest rates are a big driver for an exchange and without that policy divergence, we're not really seeing currencies move as a result.

Now we don't expect that to last much longer. However, 2024 is an important election year and the face-off between Trump and Biden is already becoming a big theme for currency markets. Traders are now associating a possible Trump win with U.S. dollar strength, and we agree that that's likely to be the kneejerk reaction. But in the longer term, we're still very negative on the U.S. dollar.

The currency is highly overvalued, fiscal credibility is waning and U.S. economic growth is set to slow against many of its peers. We're expecting a 5% to 10% decline in the currency, and we expect most other developed and emerging market currencies to benefit as a result.