Repurposing a quote from American author and political commentator Mark Twain, we believe that recent reports of the bond market’s death have been greatly exaggerated. Donald Trump’s election win does imply changes in aspects of fiscal and perhaps monetary policy. However, we believe bond fundamentals are solid and that fixed income should remain a core component of a balanced investment portfolio.
We’ve talked about the post-post-crisis era as one that is neither risk-off (a period like the financial crisis, when investors shun riskier assets) nor risk-on (a period like the post-crisis period, which we define from March 2009 through November 2014, when investors embrace riskier assets). In a post-post-crisis landscape, markets have a mixed outlook, in which growth is uneven and interest rates remain low. Although a lot has changed in politics with a new Republican president and Republican-majority Congress, we believe that the post-post-crisis framework remains relevant. In this piece, we will analyze the catalysts for the yields moving higher recently and provide information on why we continue to believe that bonds are a sound investment.
The Taper Tantrum vs. the Recent Rise in Yields
Before we discuss prospects for bonds going forward, let’s consider where interest rates are today compared to the recent past.
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In 2013, the “Taper Tantrum” occurred when the market learned that the Federal Reserve planned to wind down its quantitative easing program — signaling the end of monetary policy easing and the beginning of a shift toward monetary policy tightening. Consequently, Treasury yields rose 100 basis points over two months. The move higher in yields seemed like a reasonable reaction to such signaling.
Similarly, in the week following the election, 10-year Treasury yields had moved approximately 70 basis points higher from their early-September lows. At that time, the expected number of Fed rate increases through the end of 2017 rose from 1.4 to 2.4 hikes.
The recent move in interest rates also makes sense. The market is taking several things into consideration:
1. Uncertainty about the leadership of the Fed. Janet Yellen’s term as chair is due to end in February 2018. Given the Fed’s dovish policy during her tenure, the market is fearful that Trump will appoint a more hawkish leader who is more eager to raise interest rates and reset the tone.
2. Looser fiscal policy. Trump has championed both lower taxes and higher infrastructure spending. These policies, if implemented, would likely boost gross domestic product and increase the federal budget deficit. Both stronger growth and a wider deficit are factors that tend to move yields higher.
3. Higher inflation prospects. Looser fiscal policy should be a tail wind for inflation. In addition, any protectionist policies, such as amending the North American Free Trade Agreement or implementing tariffs, could cause prices to move higher. As inflation expectations rise, bondholders require more yield to compensate for that risk.
In the next part, we’ll look at bond fundamentals and yields both in the U.S. and Internationally.