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November 8th 2016 - on election results night, all political calculations went awry in the U.S.A. In the days that followed, so did investors' calculations for bond markets. Bond yields jumped nearly fifty basis points, to levels not seen since 2008. The prompt dip in stock markets showed that the numbers there too had been wrong. The reason for this global flap was of course was Mr Trump's unexpected victory.
The real story is that the bond sell-out was even more surprising than Trump's victory. It resulted in wiping out 1$ trillion from world bond markets. "There has been a huge repricing in the bond market, as we have a new game in town,'' said Jason Evans, co-founder of hedge fund NineAlpha Capital LP in New York. "But there are lots of crosscurrents," he said, including uncertain policy details from President-elect Donald Trump. (Wall Street Journal, Min Zeng and Christopher Whittall) Nov. 15, 2016)
US woke up to a new phenomenon - Trumpflation - inflation expectations from Trump's promised economic agenda.
Higher interest rates from higher inflation expectations
Since the election, the benchmark 10-year Treasury has jumped from a yield of 1.80% to 2.30%. It has moved higher with the dollar, which is up about 2.5% against a basket of currencies. The 30-year bond yield has also crossed the psychological 3% level. "Before, the fair value was closer to 1.50 on the 10-year and now the fair value is 2.50 and we basically got to 2.30 overnight. We went from a world starving for yield and people chasing bond markets to very low rates, which was wrong," says George Goncalves, head of rate strategy at Nomura. "Now you could get upside of 25 basis points and you could get 25 basis points downside."
US mortgage rates, by and large are linked to 10- Year bond yields. Higher bond yields therefore could mean higher borrowing costs for corporates. Average rates on 30-year fixed conforming mortgages hit 4%, also the highest since January, according to MortgageNewsDaily.com, and up nearly 0.4 percentage points` since the election. While still only roughly half the average over the past 45 years, according to Freddie Mac, the quick rise has lenders worried that home loans could become more expensive far sooner than anticipated.
Debt issued by U.S. companies has been hit as well. While the S&P 500 is up 1.2% since last Tuesday, the iShares iBoxx $ Investment Grade Corporate Bond ETF has fallen 2.5%. The iShares iBoxx $ High Yield Corporate Bond ETF, which tracks bonds issued by junk-rated companies, fell 2.2%. (Wall Street Journal Nov. 15, 2016)
Expect higher US fiscal deficits
Trump's victory has created an expectation of higher fiscal deficits, given his extravagant promises on renewing American infrastructure. Obviously, higher deficits mean a bigger US government debt and higher inflation.
"I think there's a fundamental rethink in the near-term outlook, as it relates to expectations for growth and also (Federal Reserve) policy. All of this has to do with increased optimism that there will be some fiscal stimulus in the near term and some type of deregulation, both of which will underpin growth," said Mark Cabana, head of U.S. short rate strategy at Bank of America Merrill Lynch. (cnbc.com Patti Domm, November 14, 2016)
Adds Cabana, "this should increase the estimate of the deficit. One of the scorers estimated Trump's plan could add $5 trillion to the deficit. We seriously doubt that. You do have deficit-conscious hawks in the House, which will try to limit anything that materially adds to the deficit."
Peaking economic performance
All this would not matter so much if the developments are likely to promote stronger economic growth and reasonable inflation. However recent economic data paints a different picture. According to the Wall Street Journal - the metrics that use market data to gauge inflation expectations are rising. In the U.S., the 10-year break-even rate-the yield premium investors demand to hold the 10-year Treasury note relative to the 10-year inflation-protected security, rose to 1.93 percentage points during Monday's session, a two-year high. At that level, it suggests that investors are expecting the U.S. inflation rate to be 1.93% on average over the next 10 years. The break-even rate fell below 1.4% shortly after the Brexit referendum, but is now moving toward the Fed's 2% inflation target.
Investors now expect that the Federal Reserve will hike rates to cool rising inflation. Money managers now say that there is an 86% probability of a rate hike in December, while the chances were put at 81% during election week.
"The derivatives market is beginning to price in a more aggressive Fed. A few days before the election, investors learned that average hourly earnings rose by 2.8% year-over-year. This is the fastest in several years, and although one month a trend does not make, it is consistent with a tightening of the labor market, and rising core inflation pressures," wrote Marc Chandler, head of foreign exchange strategy at Brown Brothers Harriman. (cnbc.com Patti Domm, November 14, 2016)
U.S. becomes a global magnet for investment
Another factor that is worrisome is that increasing U.S. yields makes it a much more attractive destination for investments. Investors are already pulling money out of emerging markets and putting it in U.S. markets. If this trend continues and indeed increases, it could mean a capital flight from emerging markets to U.S. markets. This has big implications for countries across the world, which may now be forced to borrow at higher rates. This will increase costs and fuel inflation in precisely those geographies that can least afford them.
Cabana said he now believes that the Fed's forecast for one hike this year and two next year may actually work out, as opposed to overly optimistic forecasts the Fed has repeatedly pared back. He said BofA economists have pared back their growth forecast slightly to 1.9% for next year based on the uncertainty around a Trump presidency. (cnbc.com Patti Domm, November 14, 2016)
EMs need to fight harder for global liquidity
On the whole, analysts say that it is too early to predict the future course of the US economy. It is also a fact that low interest rates are hurting pension funds, insurance companies and banks. Trump has said many things about how he will fix America's 'broken' economy. The only consistent thing he has said is that there will be tax cuts. To be fair to Trump, his administration is still a work in progress. The public at large will get to know his actual policies only as he settles down into office and his programs become more granular.
"We're moving away from an Obama administration to a Trump administration, which has clearly a different priority set, and the economy is going to have to retool and recalibrate, and that's going to mean disruption. That doesn't mean a recession. It just means changes, as we adjust to the new world," said Goncalves. (cnbc.com Patti Domm, November 14, 2016)
One thing is however very clear, and the market has already witnessed it: as US gets ready for a healthy dose of infrastructure growth led inflation, money is gushing into the US dollar and into US stocks - and away from emerging market currencies, EM bonds and EM stocks. Money is not going to come gushing into Indian and other emerging markets simply because a US pension fund had nowhere else to invest. We've got competition now - and our market, our fundamentals need to fight harder to earn that FII dollar going forward. Trumpflation is resetting market expectations, literally across the world.
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