In hindsight, it is quite clear that I, and the markets for that matter, didn’t assign a high enough probability to a Donald Trump election victory. Because if we had, it would be quite obvious that the near-term outlook for bonds was going to weaken irrespective of the U.S. Federal Reserve’s (the Fed) tightening. Even if the Fed is gradual in its tightening, which I still very much believe it will be, the outlook for bonds, at least in the beginning, is not likely to be so sanguine.
A president who is committed to fiscal expansion, we should have assumed, would change the conversation from disinflation or deflation to inflation. That is now playing out in the market. The massive sell-off in long term bonds and the ensuing curve steepening is the direct consequence of this stimulus-induced reflationary talk.
The bigger, and perhaps more relevant, questions are, “Where to now?” and “Where to in the long term?”
Where to Now?
The now part is relatively straightforward: If Trump follows through with his large tax cut and infrastructure spending program in an economy at the current level of employment, there is no reason for real rates to be near zero. I believe that in all likelihood, the fiscal stimulus currently proposed by President-elect Trump would likely drive real interest rates and inflation expectations higher, which in turn would also drive interest rates higher on a nominal basis as well (Exhibit 1). With inflation at 2% and real rates at, say 1%, one can assume that the yield on the 10-year U.S. Treasury bond could go into the 3% range in the near-term in a worst-case scenario. For that scenario to happen, the stimulus and/or tax cuts would have to be substantial enough and at levels that can’t be paid for. In other words, the Republican Congress will have to go along with the will of Donald Trump and bear with its distaste for deficit spending. That being said, it is also quite probable that a lot of that sell-off has already been priced in. And the markets may pause and look for some proof statements before continuing to sell off further. In addition, for the sell off to continue, credit markets have to hold up. If they do not, corporate borrowing will slow down and the prospect of a recession due to tightening financial conditions will become quite real even before the Trump stimulus happens.
Watch credit spreads, as they will tell you how likely it is for events to break this way in the near term. I believe the barometer for the markets has to change from the dollar to credit spreads as a strong dollar, in conjunction with large U.S. deficit and borrowings, are not entirely inconsistent.
Where to in the Longer Term?
This is a much trickier question. Rates in the long run, especially in a free global market for capital, are effectively a savings- and borrowing-derived equilibrium. In the long term, for rates to be higher, the demand for capital has to be significantly higher than the supply of savings. On that front, savings in Asia and Europe, and to some extent in the United States, will remain high for structural reasons. So, for rates to move permanently higher, there effectively has to be large sovereign or quasi-sovereign borrowers on a global basis. For now, at least, China and most of Asia continue to deploy their own savings at home; and the increased U.S. sovereign borrowings, in conjunction with U.S. corporate borrowing, can get rates higher. But for rates to remain high for a long period, that borrowing has to be persistent, as was the case with the U.S. consumer sector for two decades before the global financial crisis of 2008. In my view, the likelihood that the level of borrowing by the U.S. government and corporate sector will remain persistently high is questionable.
A Mixed Outlook
So, in the near term, it seems the path of least resistance is for rates to be higher, assuming credit spreads hold up. But longer term, the picture is far less clear. A long-term deficit-enamored presidency and Congress are what we will need, but what we may or may not get. We shall see.
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