U.S. interest rates jumped sharply on November 9th when Donald Trump was called the winner of the U.S. presidential election, which sent bonds plummeting. Today, I will describe market expectations that I think triggered the latest selloff.
When it stopped buying bonds in 2014, the Fed’s began the long, drawn-out process of normalizing its policy. This normalization means that the Fed is gradually stepping away from suppressing long-term interest rates, and is “handing it off” back to market forces. I described in my previous blogs the market forces that increasingly drive interest rates – inflation, currency markets, and the Chinese yuan now being used as reserve currency. These three market forces began to drive Treasury yields up (bond prices down) since July – for example, total CPI inflation rose from 1.1% to 1.5% in September.
With that as backdrop, let us look at expected effect of some of president-elect Trump’s proposed policies.
1. During his campaign, Mr. Trump said that by maintaining its accommodative policies for so long, the Fed is being “political,” aiming to keep the economy stable in order to burnish President Obama’s legacy and help Hillary Clinton slide into the presidency. We should expect changes at the Fed under the Trump administration, including a new Fed Chairman. This will likely accelerate the “hand-off” of interest rates to market forces.
2. Trump’s team outlined several economic actions in his Contract with the American Voter (the 100-Day Plan), designed to grow the economy 4% per year. The market is beginning to view them as positive for U.S. economic growth, at least judging by the stock market rally in the days since the election. Quicker growth would mean higher inflation and interest rates.
3. Trump proposed to lower taxes significantly, including lowering individual taxes and dropping business tax rate from 35% to 15%. However, Treasury debt doubled under the Obama administration to $20 trillion, and budget deficits continue to run around $500 billion per year. If quicker economic growth and/or lower government spending materialize, it will help with budget/debt in the long run. But lower tax receipts in the short term might mean larger deficits and higher Treasury borrowing costs.
All these measures seem to point toward higher future inflation and interest rates.
Bond ETF Performance: 5 Years
Source: market data, 5 years ending on Nov 14, 2016
I wrote in my Oct-27th post “the 1.80% level [on the 10y Treasury] was breached today, so 2% is now within striking distance. This is probably the baseline, most likely scenario in the short term.” The election of Donald Trump proved to be a crucial catalyst that made this happen quicker than I thought. After being already up in October, the 10-year yield continued to rise. It jumped by 20 basis points on November 9th, the day after the election, and bond prices plunged. The 10y yield now trades around 2.2%. The chart above shows 5-year performance for popular bond index ETFs. Here is their performance since June 30th:
- Barclays U.S. Aggregate bond index: -2.4%
- iBoxx Investment Grade Corporate Bond index: -2.7%
- 7-10 Year Treasury index: -4.8%
- Long Treasury bonds: -11.4%
What’s next? The 2.3% level on the 10-year yield might attract some institutional buying, so the rise may pause there and fluctuate around it. The risks to this scenario are if October inflation rises to any material extent, or if China’s Treasury holdings decline again next month. If any of it occurs, it may trigger panic and push bonds lower yet again. Stay tuned.
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Important disclosures: Roman Chuyan is the president and general partner of Model Capital Management LLC, a Registered Investment Adviser. This article is for informational purposes only. There are risks involved in investing, including loss of principal. Roman Chuyan makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Model Capital Management LLC. There is no guarantee that the goals of the strategies discussed in this article will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any security.