The election of Donald Trump has brought about sweeping changes to some long-held market views. The low for long interest rate regime that was firmly in place before the election has notably been dislodged in the weeks since the election, as the yield on the 10-year U.S. Treasury bond increased over 50 basis points. What has driven this change and can it persist? If it does, how can investors position themselves in this new environment?
The view of my team is that the change in the bond market has been driven by a few key factors. This scenario was set in motion by some of President-Elect Trump’s stated policy goals, including:
• Fiscal stimulus in the form of tax cuts for corporations and individuals, as well as incentives to bring offshore cash back on shore.
• Fiscal stimulus in the form of increased infrastructure spending.
These measures would be constructive for growth in the United States, and that could enable a normalization of interest rate policy, which would bring an upward pressure on rates. In addition, this stimulus would come at a time when the United States is closer to full employment, a circumstance that could potentially lead to inflation and a further need for higher rates.
While on the campaign trail, President-Elect Trump was very critical of the policies of U.S. Federal Reserve Chair Janet Yellen to keep interest rates low. He is likely to appoint a more hawkish head of the Federal Reserve (the Fed) when Yellen’s term expires early in 2018. He could also name sympathetic appointees to replace the two members of the Fed’s seven-person board of governors whose terms will expire over the next four years. These new appointees could bring an end to the dovish approach to interest rates that the Federal Reserve has taken for some time.
These developments, along with President-Elect Trump’s stated goals for trade policy, could create a new climate for trade:
There could potentially be tariffs or taxes on imported goods. Both would increase the cost of goods being purchased from abroad and bring inflationary pressures. These changes could also spark growth in the capacity of U.S. companies to manufacture goods and provide services, as they respond to the surge in demand for their relatively lower-priced products and services.
These trade policies could also spark retaliation abroad if other countries impose tariffs on U.S. exports―measures that could dampen global trade. In the long run, these new trade policies could hurt global growth and cause friction in the global economy.
One of Trump’s stated goals in renegotiating trade deals is to increase manufacturing capacity in the United States and displace capacity that is currently located abroad. If that effort succeeds, it will likely lead to a transitional period when the U.S. is undersupplied as the capacity comes on line here, and that circumstance would bring upward pressure on domestic pricing. Outside of the United States, the capacity that is currently filling U.S. demand is not likely to be shuttered quickly. That could lead to excess supply outside of the United States, which could put downward pressure on the prices of the goods and services produced in other countries.
This combination of upward pressure on pricing in the United States and downward pressure on pricing outside the United States could keep U.S. interest rates higher than international rates―and that would put upward pressure on the dollar. If the end of easy monetary policy in the United States is followed by, as an example, a decision by the European Central Bank to taper bond purchases, that could be the start of interest rates increasing in other parts of the world as well.
What Are the Implications for Investors?
We have been concerned for some time that eventually the 35-year bull market in interest rates would come to an end and that rates would begin to reverse direction. That scenario would cause fixed income assets with higher duration―that is, greater interest rate sensitivity―to underperform, and certain assets, like investment-grade debt that had served as strong portfolio diversifiers, to be less effective in doing so.
As evidence of that, consider what has happened since the U.S. election:
From November 8 through the date of this blog on December 7, 2016, the Barclays Aggregate Bond Index was down over 2.5%. That is a quick move in just a few weeks. This occurred alongside an equity market rally. The real problem for investors would come in a scenario in which both equities and U.S. Treasuries sold off simultaneously, as that would leave their portfolios without anything to cushion the markets’ fall.
To determine if we are at risk of such a scenario playing out, we looked at the correlation between stocks and bonds going back several decades.