Understanding Why the Bond Market Fell after Tax Reform News
Are tax cuts good or bad for bond markets?
In general, tax cuts are considered positive. Lower corporate and individual taxes boost consumers’ spending power, which increases the demand for goods. This demand results in higher economic growth and possibly higher levels of inflation (VTIP). Also, productivity improves as workers increase their hours due to lower taxes.
Whereas President Trump’s proposal to lower corporate tax is good news for equity markets (SPY), bond markets (BND) think otherwise. Bond market (AGG) traders may question how the reduction in government income due to lower taxes would be compensated. The prospect of a larger deficit in the absence of new sources of revenue is likely to push bond yields higher.
Bond market reaction to tax reform announcement
With the Fed signaling another rate hike by the end of this year, the tax reform announcement was a second blow to bond markets. Both announcements pushed bond yields higher. Rate hikes from the Fed warrant higher yields, and the possibility of a ballooning deficit because of tax cuts helped yields move higher in longer-term maturity (TLT) bonds.
Bond markets are likely to remain skeptical
Though there was a knee-jerk reaction after President Trump’s tax reform announcement, bond markets are likely to remain skeptical until the bill is approved by Congress. Volatility (VXX) is likely to remain high as the political drama unfolds.