Is the Rout in the Bond Market Over?

Lots of comments suggest that the plunge in bond prices is too much, too fast.  According to this view, investors have acted pre-emptively in direct response to Trump’s victory and are already building substantial expectations for infrastructure spending, defense spending, household and corporate tax cuts, wiping out the estate tax, and deregulation that will stoke investment and consumer spending all without a single specific legislative proposal, nor any sense of what can actually emerge from Congress.  All true.  But it is also very risky to assume that Trump will fail to meet any of his objectives, when the labor market is already tight and labor costs and inflation are already accelerating even before any new policies are implemented.  Interest rates were simply too low for these conditions.  A taxable 2.30% yield on 10-year Treasuries is still inadequate to compensate investors when the Fed has a 2% inflation objective that is already exceeded by most inflation measures, except the Fed’s Consumption Expenditures Deflator, which is almost there.  So, we expect further declines in bond prices until Treasury yields comfortably exceed 4%.

Investors were being entirely realistic when they promptly started selling bonds after Trump’s victory.  As noted by many critics, Trump’s tax and spending initiatives were floated without much explanation for how they would be financed.  Even traditional Republicans may well oppose some of these initiatives to keep the deficit from growing.  But with much of the Republican leadership seeking to find common ground with the iconoclastic President, it is highly likely that many of his fiscal proposals will be approved, even if we can’t guess which ones will emerge from the messy political process that will also involve trade-offs with Democrats, who retain the ability to filibuster.  Still, Democrats may accept some Trump proposals in trade to preserve some Obama policies.  Moreover, deregulation and quick approval of assorted pipeline projects, such as Keystone XL and Dakota Access are likely to occur very soon, unleashing private sector spending.  There’s little doubt that policy will be far more expansion oriented.  This would be helpful, if unemployment were elevated, but it’s not.

It remains our judgment that the labor market is tight and getting tighter and this is already showing up in the wage and price inflation data.  Increased spending will only exacerbate this problem.  Moreover, recent data indicates that the economy was performing even better than expected as we entered the fourth quarter.  So the Fed may need to turn monetary policy less accommodative, partly because fiscal policy is becoming more so.  Like most everyone else, we expect a rate hike at the Fed’s December meeting.  But the Fed’s ability to act slowly next year, as Yellen has promised, is highly dependent on inflation moving up only very slowly, despite tight labor market conditions.

Keeping our bond maturities very short is one of the key ways we prepared for these conditions.  We also minimized our exposure to the lowest coupon, highest grade securities, since they are also vulnerable to rising rates.   Bond ETFs are also highly vulnerable due to their duration, so we have focused on bank loan and floating rate ETFs in our model portfolios.  We are also staying away from funds that hold illiquid assets that could sell off drastically if investors continue pulling money out of these bond funds, forcing the managers to sell holdings.  With yields so low, the bond market is a treacherous place to invest, providing little return but plenty of risk.

So, how much could bond yields rise?  Looking strictly at U.S. economic conditions, a 2% inflation rate would be consistent with a neutral monetary policy with the Fed funds rate at 4%, 10-year Treasuries at around 4.5%, and 30-year Treasuries at around 5%, all significantly above prevailing rates.  Monetary policy would still be expansion oriented with anything meaningfully below those levels.  It gets more complicated when international considerations come into play.  The rising dollar will create a headwind, but not for at least a few quarters.  And central banks around the world are becoming less inclined to support negative rates, so bond yields have also increased overseas, providing more competition for U.S. bonds.  Moreover, if growth does pick up in the U.S., it will support stronger activity overseas.  In any case, these factors will take some time to unfold, while the near-term pressures towards higher interest rates will remain in place, at least for the next three to six months.  Bond investors need to remain positioned defensively.

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