How Donald Trump blew up the bond market and changed everyone’s view of interest rates
In a flash, the world has changed for bond investors, savers and borrowers.
President-elect Donald Trump’s White House victory was a surprise, and so is the ripping sell-off in global bond markets, which has quickly driven U.S. interest rates to the highest levels in a year. The rout has wiped out an estimated $1 trillion from global bond markets and has Wall Street scrambling to retool its forecasts.
The sell-off comes on the expectation that Trump’s promised infrastructure spending and tax cuts will result in higher growth — but also higher inflation and higher amounts of U.S. government debt.
‘A fundamental rethink’
“I think there’s a fundamental rethink in the near-term outlook, as it relates to expectations for growth and also (Federal Reserve) policy. All of this has to do with increased optimism that there will be some fiscal stimulus in the near term and some type of deregulation, both of which will underpin growth,” said Mark Cabana, head of U.S. short rate strategy at Bank of America Merrill Lynch.
Since last week’s election, the benchmark 10-year Treasury has gone from a yield of 1.80 to 2.30 percent. It has moved higher with the dollar, which is up about 2.5 percent against a basket of currencies. The 30-year bond yield crossed the psychological 3 percent level Monday.
Mortgages and other financing are based on the 10-year, and fixed-rate and other mortgages are already on the rise. The 30-year fixed rate mortgage is also up a half percent since Trump was elected. It jumped an eighth of a point Monday, to the psychologically important 4 percent level.
So far, the stock market has taken the rise in yields in stride and is rallying. But the move in interest rates will create ripples across the economy.
“If you’re going to buy a house and your mortgage payment went up by $200 or $300, you may buy a smaller house. There’s impact on interest rate sensitive sectors, like autos and housing, and also corporate bonds themselves, where financial engineering has helped juice up the equity market,” said George Goncalves, head of rate strategy at Nomura. With extreme low interest rates, U.S. corporations had been loading up on debt and using proceeds to pay for stock buybacks and dividends, among other things.
For financial institutions, it’s a major positive to have rates rise, and their stocks have been flying since Trump’s election. The S&P financial sector was up 2 percent Monday, after an 11 percent gain last week. Savers will also be helped, as interest rates on Treasurys and money markets edge higher.
“Before the fair value was closer to 1.50 on the 10-year and now the fair value is 2.50 and we basically got to 2.30 overnight. We went from a world starving for yield and people chasing bond markets to very low rates, which was wrong,” said Goncalves. “Now you could get upside of 25 basis points and you could get 25 basis points downside.”
U.S. interest rates have been held down by Fed policy and sluggish U.S. growth, but they have also been distorted by super-low and negative yields, courtesy of central banks in Europe and Japan. Now, the U.S. Treasury market, like a once sleeping giant, is dragging world rates higher with it. Bond yields move inversely to bond prices.
Even the short end of the yield curve, which is tied closest to Fed policy, has seen a steep rise. The 2-year yield rose above 1 percent briefly on Monday and some bond market experts say it could easily reach 1.5 percent in the next year.
Goncalves said his forecast for the 10-year had been 2 percent next year, as he and many on Wall Street were basing their expectations on a Hillary Clinton victory and a status quo situation in Washington and in the markets.
But the “lower for longer” theme, where the Fed was expected to keep rates low for a very long time, has been smashed, and even Fed officials concede Trumponomics may force them to adjust their policy outlook if it sparks economic growth and inflation.
“The derivatives market is beginning to price in a more aggressive Fed. A few days before the election, investors learned that average hourly earnings rose by 2.8 percent year-over-year. This is the fastest in several years, and although one month a trend does not make, it is consistent with a tightening of the labor market, and rising core inflation pressures,” wrote Marc Chandler, head of foreign exchange strategy at Brown Brothers Harriman.
Cabana said he now believes that the Fed’s forecast for one hike this year and two next year may actually work out, as opposed to overly optimistic forecasts the Fed has repeatedly pared back. He said Bof A economists have pared back their growth forecast slightly to 1.9 percent for next year based on the uncertainty around a Trump presidency.
Some of the uncertainties that have worried the market revolve around Trump’s plans for trade, and whether he could start a trade war with China and others.
“We do think all of this means the Fed will likely have to be more active. We are going to hear from Chair (Janet) Yellen this week. She is likely to reiterate a December hike is on the table, and any type of fiscal stimulus will be well received,” said Cabana. Fed officials and central bankers globally have called for fiscal stimulus to prod growth, since they have come to the point where more monetary policy has become questionable in terms of its ability to stimulate growth.
“We’re moving away from an Obama administration to a Trump administration, which has clearly a different priority set, and the economy is going to have to retool and recalibrate, and that’s going to mean disruption. That doesn’t mean a recession. It just means changes, as we adjust to the new world.”
Strategists say a Clinton win would have meant a very different bond market.
“Maybe that would have been 10 to 15 basis points. Nothing like this kind of move we’ve made. It’s because you would have (had) continued gridlock in Washington. The Republicans would have continued to hold the House and that would have been a continued gridlock,” Cabana said.While the market is reacting to the potential for economic positives and inflation, Goncalves said it appears to have been too optimistic, and the rise in yields could be closing in on a near-term top. “We’re moving away from an Obama administration to a Trump administration, which has clearly a different priority set, and the economy is going to have to retool and recalibrate, and that’s going to mean disruption. That doesn’t mean a recession. It just means changes, as we adjust to the new world,” said Goncalves.
Cabana said the spending plan should add more debt. “This should increase the estimate of the deficit. One of the scorers estimated Trump’s plan could add $5 trillion to the deficit. We seriously doubt that. You do have deficit-conscious hawks in the House, which will try to limit anything that materially adds to the deficit,” he said.
Cabana said the move in yields, if it continues too quickly, could become a negative in that it could create tighter financial conditions. That would change the outlook for the Fed, and hurt emerging markets and stocks.
“At 2.5 (percent on the 10-year), we might start to begin looking to fade. We might see a level around there as fair,” he said.