Why We Believe Reports of the Bond Market’s Death Have Been Greatly Exaggerated
To paraphrase Mark Twain, recent reports of the bond market’s death have been greatly exaggerated in our view. While Donald Trump’s election changes aspects of fiscal and perhaps monetary policy, the fundamentals for bonds appear to be solid, and we think fixed income should remain a core component of a balanced investment portfolio.
In fact, the post-crisis landscape of mixed markets with uneven growth and prolonged low rates is likely to persist for a number of reasons.
Why Have Yields Jumped?
Ten-year Treasury yields have moved notably higher from their early September lows. This is somewhat comparable to 2013’s “taper tantrum,” when yields rose as the market learned that the Federal Reserve was planning to wind down its monetary stimulus program. The market appears to be reacting to three significant changes a Trump presidency might bring:
1 Uncertainty about the leadership of the Fed.
Janet Yellen’s term as chair is due to end in February 2018. At that time, Trump could appoint a more hawkish leader who is eager to raise interest rates.
2 Looser fiscal policy.
Trump has championed both lower taxes and higher infrastructure spending. These policies would likely boost growth and increase the federal budget deficit, factors that tend to move yields higher.
3 Higher inflation prospects.
Looser fiscal policy and protectionist measures such as tariffs could cause prices to move higher. As inflation expectations rise, bondholders require more yield to compensate for that risk.
How Uncertainties and Other Factors Could Affect Bond Fundamentals
The recent move in bond yields is mostly justified by new information the market has received. However, there are still many uncertainties that provide reasons to be constructive on fixed income:
1 Shifting geopolitical backdrop.
Nonperforming loans in China may indicate that the credit expansion aiding its growth could slow. In Europe, populist political movements exemplified by the U.K.’s vote to exit the European Union threaten to shake up the status quo.
2 Uncertain U.S. government policy.
Following the election in Washington, many aspects of government policy are in flux, from spending plans to foreign relations.
3 Risk that fiscal stimulus plans miss their target.
The nonpartisan Tax Policy Center estimates that high-income families will benefit most from Trump’s tax plan, with a smaller break for the middle class. If it results in a relatively light boost to consumer spending, its broader economic impact could be muted. The effect of an infrastructure package could also take time if implementation is slow.
4 Potential for a trade war to harm growth.
If Trump follows through on his proposals to increase tariffs, his actions could spiral into a trade war. Sales from abroad account for 44% of the S&P 500 companies’ sales, so a change in trade policies could hit company earnings.
5 Threat of immigration restrictions hurting economic growth.
One little-known fact is that growth in GDP per capita has trailed total GDP growth by 40% since the financial crisis. Significantly curbing immigration could create a demographic headwind for U.S. growth.
6 Risk of a shock hitting the economy.
Since current U.S. growth remains relatively modest, it could be vulnerable to an external shock. Tightening financial conditions due to higher interest rates could also cause a downturn. The current post-recession expansion at 89 months is well past the 58-month post-war average.
7 Continuation in the large number of buyers of U.S. government debt.
U.S. and foreign pension funds and insurers use Treasuries as an important component of their portfolios. If interest rates rise, they may take advantage of the chance to hedge their liabilities at a lower cost than before. Many institutions overseas also buy Treasuries to manage their portfolios – and their yields are attractive compared to other developed-market government bonds.
Although many market participants fear that the bond bull market is over, particularly given some of the policies proposed by President-elect Trump,that is far from certain. Another Mark Twain quote resonates here: “Whenever you find yourself on the side of the majority, it is time to pause and reflect.”