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 this morning, although with a less extreme tone. Our note this week will focus on the known, as well as the unknown, impacts of the election results on our market.
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.
U.S. Treasury Rate Movements 11/8 – 11/14
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.
Where We Stand Now
What a wild ride this year. While the bond sell-off last week was acute, 10yr and 30yr Treasury rates remain just below where they started the year and performance is still solidly positive in 2016. Through last week, year-to-date performance in our Short, Intermediate and Long duration strategies across all sectors was positive between 1% and 3%.
Could the Sell-Off Continue?
The unpredictable price action last week in many ways validates our 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 our clients 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.
10yr UST vs 10yr German Bund
10yr UST vs 10yr Japanese Gov’t Bond
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 and is something we are watching very closely. 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. We’ve also heard rumors of Fed Chair Yellen stepping down before her term expires in 2018 – we think this is highly unlikely.
We’ll continue to stick to our knitting, being very judicious in our selection of credits and focusing our investments on entities with stable, if not improving, credit profiles. We’ll also continue to take what the market gives us in terms of sector allocation and relative value. Investing in an uncertain environment is certainly nothing new for us.