What does Trump's win mean for bonds?
We discuss some of the implications of the US presidential election result for the global bond market.
Unstructured Learning Time
The initial market reaction to Donald Trump’s US election victory is mostly as would be expected. US Treasury yields are mostly higher, with the yield curve steeper and the largest changes occurring in 30-year yields.
Long term interest rates are pricing in a combination of greater funding needs from lower taxes and greater fiscal stimulus, but it is also because of larger uncertainty due to the myriad of policy changes that must be considered in the coming months – many of which have inflationary consequences. Not surprisingly, short term Treasury yields are lower as the odds of a December Federal Reserve interest rate hike have fallen substantially. Meanwhile, inflation break-even rates, which reflect inflation expectations, are initially much stronger this morning.
US credit spreads, the difference between government and corporate borrowing rates, are initially wider, in keeping with the early losses in equity markets. We associate higher credit spreads with both a higher risk premium needed until we have better policy clarity, and also some extrapolation of known initiatives such as reduced trade which are expected to marginally detract from growth.
So far the moves in both interest rates and corporate risk premia are relatively small and should continue to be volatile in the near term. Over the next few months we expect non-Treasury securities in the US bond markets to carry marginally higher yield spreads simply because of the lack of detail on policy across a very broad range of topics.
The economic impact of a Trump presidency will not be known for a long time, and the pricing of higher risk assets will ultimately depend on how much Trump’s policies moderate as he approaches taking office. In the very near term, neither household nor corporate spending decisions are likely to be heavily impacted by election results, suggesting a cautious but not overly defensive investment strategy remains appropriate.
One likely implication of the Republican sweep is that years of political gridlock are over and we should ultimately expect higher fiscal stimulus, deregulation and tax reform, all of which suggest higher interest rates once we get through the near term uncertainty.
Away from the US
Outside the US, markets have adjusted quickly and more abruptly. The initial 8% decline in the Mexican peso versus the US dollar and the 2-5% decline in equity markets of countries with large export shares to the US are consistent with expected protectionist policies.
However, further moves are hard to predict at this time. The possibility of either a move away from extremist polices toward a more balanced approach as well as the risk of further antagonistic comments on foreign policy are both large and warrant a cautious and nimble approach to global markets.
Levels of risk exposure across our fixed income desks are moderate. The rally in corporate bond markets over the summer afforded profit-taking in most portfolios and credit risk levels are generally about as low as they have been in several years. Moreover, portfolios are constructed with longer-term uncertainties in mind. Most of the positioning is driven by longer term fundamentals where good value is evident, and there are few trades dependent on short term momentum. In this respect, the immediate impact on our fixed income portfolios is relatively light.
Having “dry powder” in this environment will both minimise near-term volatility and allow redeployment of risk as and when policy clarity creates better opportunities in the coming weeks.