Trumped Up Rates

Viewpoints

November 18, 2016



“Don’t read the book until you’ve opened it up.”

What Just Happened?

Following Donald Trump’s surprising election victory, 10-year Treasury yields have sold off 50 basis points (bps) to 2.35%. Trump’s emphasis on “unifying” and “spending” in his victory speech, combined with Republican control of the House and Senate, has convinced the market that there will be tax cuts and some fiscal stimulus in an effort to spur the economy. Government deficits will widen due to the combination of lower revenues and higher expenditures. This will require an increase in Treasury issuance.

While risk assets have rejoiced at the prospect of less regulation and increased economic tailwinds, bonds have been battered in the steepening move to higher yields. Breaking down the 50 bps rate increase by analyzing Treasury Inflation Protected securities (TIPs), 10-year real yields moved 30 bps higher while inflation break-evens widened 20 bps. Hence, the rates market is roughly attributing the move to 60% higher real growth expectations and 40% increased inflation expectations.

Is Tomorrow’s Glass Half Full?

Given that the old paradigm was not generating sufficient real economic growth, newfound hope for a better economy is somewhat justified. Lower corporate taxes should spur investment, lower personal taxes should increase disposable income and consumer spending, infrastructure spending should have some positive multiplier on the economy, and reduced regulations should unshackle many industries from their previous constraints.

Yet, some degree of pessimism is also justified. Despite President-elect Trump’s claims of seeking unity, the United States remains deeply divided from this election cycle. Meanwhile, rapidly shifting geopolitical relations could have a profound impact on the world economy. Many see this election as the second example (following Brexit) of the rise of populism, which threatens the previous order of globalization. To this end, markets will be closely watching Europe as the Italian referendum and French and German elections loom large. If Trump does follow through with his discussed trade tariffs, global growth would be negatively affected. Not to mention, even if Congress green lights infrastructure spending, the fiscal multiplier on this spending could be severely minimized by the large existing debt burden (as occurred in Japan’s failed attempt to spend their way to economic growth).

The U.S. dollar also looms large as a potential stabilizing force countering the market’s newfound economic optimism. Excess dollar strength serves as both a cap on U.S. inflation via balance of trade and a tax on foreign borrowers who have dollar-based liabilities or funding needs. Hence, past periods of dollar strength have led to short-term corrections in equities and risk assets. Currently, the dollar is strengthening to new highs as the DXY Dollar proxy has broken meaningfully above 100:

DXY Dollar Index



Source: Bloomberg

The dollar is strengthening due to expectations for a more hawkish Fed. A hike at this December’s meeting is fully priced into the market. Beyond this, the hiking pace has steepened from less than one hike per year to roughly two hikes per year. The “low for longer” status quo is being justifiably questioned in the market as new leadership may not be inclined to support a “forever friendly” Fed.

How much will the Fed change under Trump’s presidency?

Immediately following the election, President-elect Trump started walking back many of his campaign promises. The wall has become a fence, the number of proposed deportees has plunged and he has even proposed keeping parts of Obamacare. Thus, it is difficult to assess the significance of his Fed criticisms. Previously, Trump claimed that Fed Chair Janet Yellen should be “ashamed of herself” for preventing a recession during Obama’s final years in office. Now that Trump is in control and easy monetary policy is supportive of his regime, his disdain for the Fed may have also tempered.

Will Trump really want a more hawkish Fed, even if it leads to a recession during his future presidency? The market is clearly running with the idea that Trump will fill the two vacant board seats with more hawkish members and then replace Yellen with a more hawkish chair when her term is up in February 2018. This hawkish shift would lead to an attempted normalization of short-term interest rates.

Traditionally, normalizing rates leads to a recession. By definition, raising short-term borrowing costs will make business investment more costly and therefore lead to more risk-aversion among economic participants. A significant rise in the Fed funds rate will eventually invert the yield curve, which has traditionally foreshadowed imminent recessions.

There are two ways to argue the hawkish angle – either Trump will be accepting of a rate-normalization-induced recession and hope that it is minor and quickly over, or he anticipates that the economic strength from his fiscal agenda will overwhelm any economic weakness that may result from normalizing rates and therefore prevent a recession. Yet, it is unlikely that any president wants a recession on their watch. Furthermore, with the business cycle already long in the tooth at seven years running, it is unclear whether his economic agenda will provide sufficient offsetting support.

A bad recession would severely impair the Republicans chances of retaining control of Congress in the midterms. It would also impair Trump’s ability to be perceived as a business friendly leader. Thus, monetary policy may be an additional area where Trump will walk back his campaign statements.

Expect any regime changes at the Fed to be more gradual than drastic. While fiscal stimulus should provide some beneficial tailwinds for the economy, questions around implementation and lag times around realized impacts will prevent the Fed from immediately adjusting their economic forecasts and therefore monetary policy actions around this. Additionally, predictions of a “draining of the doves” at the Fed for now remain nothing more than predictions. Like much surrounding Trump’s presidential agenda, the future remains to be seen.

Conclusion:

The market reaction to Trump’s election victory was swift and vicious, especially for bond-investors. In taking control of the U.S. government, the Republicans have undeniably shifted the investment landscape. Lower taxes, fiscal spending and reduced regulations will provide economic tailwinds, but the economic headwinds of excess debt, de-globalization and a strong dollar remain. While Trump lambasted the Fed on the campaign trail, it remains to be seen if he will look to shake up the institution and risk undermining monetary policy accommodation under his presidency. Fiscal policy is taking over from monetary policy, but the handoff may be more gradual than drastic. The election has not fundamentally altered our outlook as it relates to our concern about this being the late stages of the asset price cycle. Investors should expect higher volatility as markets struggle to make sense of this new reality and heightened risk/term premium as more yield cushion against future policy uncertainty.

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