Written by Mark Nash, Investment Manager, Fixed Income Absolute Return at Jupiter Asset Management
Donald Trump’s return as the next US president introduces a new dimension to the US economy’s prospects and along with that the Federal Reserve’s policy.
Eight years ago, when Donald Trump became US president for the first time, US Treasury yields were much lower than they are now, and fiscal spending wasn’t a dominant theme. Now the 10-year bond yield is at least 200 basis points higher than the levels seen when Trump was inaugurated in January 2017.
The gap in yields reflects the starkly different economic environment between 2017 and now. Inflation is simply much higher. US interest rates are still high although the Fed has cut rates by 75 basis points in response to softening unemployment and inflation falling from its post-Covid peak.
While the rest of the world has struggled to recover after the pandemic, US growth is holding up mainly due to strong fiscal spending. The fact that the balance sheets of corporates and households are far healthier than in the post Global Financial Crisis period too has underpinned growth. Financial markets have been buoyed after Trump’s election. The broad-based S&P 500 stock index is hovering near all-time highs, the dollar index is at its highest level in a year, credit spreads have tightened further and the VIX, known as the fear gauge, has declined.
`America First’’
Trump’s ‘America first’ policies include a pledge to impose tariffs on imports and clamp down on immigration. He has also promised tax cuts, deregulation, and a reduction in bureaucracy. Will Trump’s policies call into question the Fed’s easing cycle? What will be the effect of Trump’s policies on inflation and growth? And what will be the effect on fixed income markets? Trump has pledged to impose tariffs on imports from China and the rest of the world in his bid to ramp up the domestic manufacturing capacity and make the US an investment destination. We believe the near-term impact of such a move would be higher inflation in the US as imports become expensive whilst harming growth in more export driven economies like China and Germany.
A desire to raise the nominal wages of workers, particularly at the lower end of the labour market, is another key economic pillar for Trump. Sustained inflation after the pandemic has eroded real wages of workers. However, any mass deportation as planned could reduce labour supply, push up domestic wages and pressure the profitability of companies.
Long-end bond yields have risen higher since the first rate cut in this cycle in mid-September. They have stayed at elevated levels as investors are concerned about solid US growth, the inflationary impacts of the policies above but also the potential for an even wider fiscal deficit.
Fiscal spending
Such high bond yields have made some market participants question the viability of US government finances and their ability to service the debt. But we believe such concerns are misplaced given that the debt is issued in dollars, the country’s local currency. Furthermore, the central bank could resort to quantitative easing if required to bring down yields.
The current market consensus is that a Trump government would lead to a wider fiscal deficit, but at this stage not much is known. That said, Trump was said to track the S&P500 everyday during his first term, so more fiscal stimulus does appear likely. Strong growth and higher interest rates have supported the dollar’s strength, with the dollar index now at the highest level in a year. The dollar’s fortunes are closely linked to the bond market and the correlation between the two has been very strong over the last couple of years, although the latest move in the US dollar seems to have had a lesser effect on the rise in bond yields.
A strong dollar tends to tighten financial conditions globally, further boosting capital flows into the US. Therefore, the dollar’s outlook is crucial for the US bond outlook. However, the dollar’s strength could be particularly counterproductive to Trump’s ambitions to boost US manufacturing exports.
One key known unknown is the impact of geopolitics. US Treasuries have been moving in a range for some time now and credit spreads are tight. If the dollar’s strength is accompanied by higher commodity and oil prices, bond holders might sell a part of their dollar reserve holdings to overcome a dollar scarcity. That could disrupt the fixed income and credit markets. In this context, the evolving geopolitical scenario, particularly in the Middle East and Ukraine, needs to be closely watched.
Rate cut path
Currently, the US economy is highly reliant on sustained fiscal spending to spur growth. But the growth expansion is unlikely to last long as real rates are at the highest level since 2008, which will eventually hurt private sector growth, leading to the dollar’s decline.
Such a scenario will support duration long trade and help rotation into emerging market bonds that offer attractive yields. With Trump once again at the helm, doubts have risen about the pace and depth of Fed rate cuts in the coming months as his policy measures could first push inflation higher before resulting in a decline in growth. Interestingly, Fed Chair Jerome Powell has indicated that the central bank is not in a hurry to lower rates given the economy’s strength.
It remains to be seen whether the Fed will cut rates in December. The current market pricing of policy rates reflects this uncertainty, with the terminal rate at least 70 basis points above the Fed’s neutral rate. In our view, the first 100 basis point cut will be the easier part for the Fed, while the outlook for 2025 remains uncertain. However, in the end the high starting point for real rates and the strong US dollar alongside the extreme changes Trump wants to bring, will damage growth and lower inflation globally. But this is just a reset. As rates fall, combined with more investment expenditure globally – growth and inflation will return and make the macro volatile in 2025 and beyond.
