Fundamental changes are not just of academic interest, it just seems that way .....

Wednesday 16th November 2016

  

Fundamental changes are not just of academic interest, it just seems that way .....

ref:- "Future direction of US policy set to spark bond market shake-up", The Financial Times, INSIGHT by Henny Sender, Markets and Investing

An awful lot of things changed on November 8th, and as we keep saying it'll take some time to work out just what the rise of Donald J. Trump will actually mean. We're not equipped to discuss the philosophical questions generated by his victory, and it's not really our job to comment on the desirability or otherwise of global politics taking a further lurch towards populism  --  the biggest lurch possible, in fact. We can waffle on about markets of course, but some people would argue that when set against the immediate ramifications of Trump's victory for the man and woman in the street, the fortunes of the bond market (say) are of little significance or interest.

We know what they mean ..... they'd be wrong, though. Movements in short-term rates and long-term yields for example affect all citizens deeply, not just investors and academics, and bond markets will tell us whether new policies are realistic or whether alarm bells should be rung. Looked at in that light, it seems to us that the Trump years will be a particularly sensible time to keep a very close eye on bond markets.

Post-election we've already seen the sharpest sell-off in government bonds (and spike in yields) since the "Taper Tantrum" of 2013, when then Fed Chairmen Ben Bernanke first hinted at the end of Quantitative Easing in the US. In the event, the Fed may have finished its bond-purchasing programme but (to the irritation of some) has maintained its accommodative monetary policies. So, do these new developments truly signal a fundamental change for bond markets? It certainly looks that way ..... Mr Trump's heady mix of infrastructure spending, defense spending and tax cuts mean that rates and yields must surely go higher, starting next month when the probability of a Fed rate hike is now 94%, according to markets. Good judges are telling us that we've seen the end of what amounts to a 30-year bull run in bonds, and 3% yields in 10yr Treasuries are just around the corner (last at 2.26% after July low of 1.32%).

For Ms Sender, this raises two questions: 1. "Will rising rates prove to be a good thing, or will they climb too far and threaten financial stability?" and 2. "Will any fiscal stimulus spark enough multiplier effects to put growth on a much stronger trajectory?" 

Quite ..... One might also throw in some other widespread concerns, like "Fiscal stimulus is a good thing, but can you realistically expect to be able to pay for it if you slash taxes too?" and, on the subject of tax cuts, "Won't they significantly benefit the wealthy but have little effect on the average Joe?". It's quite possible that the blue-collar working class have elected a billionaire businessman who will implement measures that will mainly boost the fortunes of ..... well, billionaire businessmen. Or those that pay taxes, anyway. What do call that? Irony? Questions for another day, and another column.

What's not in doubt is that there's no shortage of pundits who are glad to see the back of Quantitative Easing, which is still the policy of choice in Europe, the UK and Japan. There are plenty of cogent arguments in support of QE, and those areas would argue that they face a very different set of financial conditions to those in the US. Nevertheless, the arguments against it also make cogent reading and should be borne in mind:

It creates dangerous bubbles by artificially inflating the price of all financial assets

     

This also widens the inequality between the wealthy (who own assets) and the less well-off (who don't)

It encourages corporate boards to use cheap money for financial engineering (share buybacks etc) rather than for job creation or investment

We should also note that the Trump agenda signals the end of another market phenomenon that had become the norm. Highly-correlated moves of stocks and bonds, that both moved higher together on the back of QE, look to be a thing of the past as monetary stimulus is replaced by fiscal stimulus. Infrastructure spending and tax cuts are (generally) good for stocks, but they're inflationary and encourage higher rates  --  which of course is bad for bonds. Stocks and bonds moving in different directions is a fundamental change in itself, but as a reversion to how things always used to be it does somehow feel more natural.

If you believe that we have witnessed a fundamental change in bond markets, and that rising yields in the US will inevitably drag yields higher across the globe, then keep an eye on Japan where the 10yr yield has just breached zero (+0.01%, in fact). The Bank of Japan is committed to keeping the 10yr yield at or near zero, so how far above that level would they tolerate? +0.10%? If US yields keep on going, their resolve may be tested. The BoJ say they have the ammunition to buy whatever is required should it prove necessary, and such is the hunger for any sort of yield that one can also expect big private demand for any bond with a positive yield. Nevertheless, at a time when the efficacy of ultra-low monetary policy is in question , you wonder whether privately they'll be too happy about ploughing more resources into a policy they themselves don't seem particularly enamoured with.