Anticipation of the release of Trump’s economic agenda is already moving markets, despite the lack of clarity and detail, any ability to handicap enactment success, or a timetable for accomplishment. Wednesday and Thursday saw 10-year U.S. Treasury bond yields rise by a record amount. The selloff is continuing, although with a less extreme tone.
The U.S. Treasury market sold-off last week as yields rose across the curve. In what’s known as a “bear steepener,” longer-term rates rose more than short-term rates, which creates a more upward sloping yield curve.
This price action tends to occur when bond investors see signs of long-term inflationary pressure building. The belief that Trump’s policies will be fiscally expansive and will require large amounts of deficit spending to rebuild infrastructure, to pay for tax reductions and to spend on the military, have stoked inflation expectations. We think an appropriate term for this is “fiscal reflation.” While the direction of the moves was not entirely surprising given Trump’s agenda, their magnitude was significant. This volatility was likely driven by investor repositioning, as most market participants were expecting a different election result.
Riskier sectors of the bond market fared better than U.S. Treasuries last week. Yields on bonds issued by corporations and municipalities rose, but by a lesser degree than Treasuries, which led to relative outperformance in those sectors.
Could the Sell-Off Continue?
The unpredictable price action last week in many ways validates SNW’s investment philosophy of not trying to time or predict the level and direction of interest rates. So when asked if rates will now rise, we encourage you to take our (or anyone’s) answer with a grain of salt. At present, we’ll answer this question with the classic noncommittal of “maybe,” but if we had to take one side, over the next 6-12 months, all else equal, we think rates are more likely to stay low than continue accelerating dramatically to the upside.
In the near term, rates could continue rising as the “fiscal reflation” risks mentioned above are priced in, but there are also strong pressures that could keep rates low in the medium term. A trend that we have written about extensively this year, one that is not currently being discussed in the press, but is very much still in force, is the concept of foreign demand driven by rate differentials. Earlier in the year when Japanese and European sovereign rates went negative, Treasury rates fell because of demand from yield starved overseas investors. As it stands currently, rate differentials between USTs and German/Japanese sovereigns are close to their widest levels in the last five years.
As a reminder, the Bank of Japan has instituted a formal policy of holding its 10-year at a 0% rate. This makes the yield differential a critical measure of where USTs could go – currently the spread is about 20 basis points through the wides, which we think is a reasonable assessment of further downside risk for Treasuries.
Tax policy is very likely to be adjusted by the new administration. The lowering of tax rates and simplification of the tax code are a strong possibilities given Republican control of Congress, which could have the effect of reducing marginal demand for tax-exempt munis. From time to time we’ve also heard the concept of limiting the tax-exemption on municipal interest payments as a revenue generation tool, but we do not think this policy has broad political support as tax-exempt financing is still the favored way of funding infrastructure projects in the U.S.
As it relates to the Federal Reserve, we think the Fed will continue to do everything in its power to retain its independent structure. This means making monetary policy decisions based on economic data and financial conditions and not on political events. Barring an unforeseen downturn in the data, the Fed is very likely to hike rates when it meets in December as it has previously hinted. This will come as no shock to the markets, however, as futures are pricing in an 80% probability of a 25 basis point hike. The final unknown is to address the rumor of Fed Chair Yellen stepping down before her term expires in 2018, this seems unlikely.
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