Making Yields Great Again: Trump Unleashes A "Bigly Rates Repricing"

Making Yields Great Again: Trump Unleashes A "Bigly Rates Repricing"

The past two days have seen some historic moves in US Treasury rates, where as a result of a Yuuuge repricing in the long end…

… which have seen 30Y TSYs plunge 5% since Trump’s win, a stark reminder of just what “duration” means…

… leading to the biggest drop in 30Y TSYs since October 2011, when the Fed bailed out the world…

 

… sending the Yield on the 10Y to perfectly match the S&P500’s dividend yield.

 

The reason for the huge moves is simple: as we explained yesterday morning – and as we had warned weeks prior – by threatening to issue up to $5 trillion more in debt, Trump has unleashed the very same inflationary wave that the Fed had tried, and failed, for years to achieve. Trump did it in just as few hours as president-elect, confirming that in addition to everything else, Trump is making yields great again!

As for what is taking place in the market, we defer to Deutsche Bank, whose research note today, “Bigly Rates Repricing” summarizes it best.

The details which explain why DB, which until recently was very bullish on fixed income, is now bearish on fixed income and thinks that “Trump’s victory cements the shift in the policy mix”, are as follows:

Trump’s victory is fundamentally bearish fixed income from a pure economics perspective. The key risk to the view comes from increased geopolitical uncertainty.

If Trump’s economic program is taken at face value, it would imply (1) increased fiscal spending, (2) reduced regulation, (3) a change of Fed leadership and (4) increased protectionism. Each one of these factors is bearish rates.

  • First, as we highlighted last week, Trump’s plan is consistent with more than 2.5% of GDP of annual fiscal stimulus over the next ten years (see table below). Of course, the extent to which the plan will be implemented is unclear. However, Trump is arguably in a strong position relative to the Republican Party and the latter controls both the House and the Senate. This should give Trump leverage to implement his fiscal plan, at least initially. Also, one of the clear statements made by Trump in his acceptance speech was that he intends to significantly increase infrastructure spending. It is worth noting that the Fed in principle welcomes more fiscal support as it sees the US economy as being constrained by a lack of demand. Given that the fiscal stimulus will occur as the US economy is close to full employment, it should have a faster spillover on monetary policy, notwithstanding the desire from the current Fed leadership to run the economy hot. Increased fiscal spending should be supportive of higher yields from a macro perspective (supports domestic demand and inflation) and from a flow perspective (reduces the supply/demand imbalance).
  • Second, Trump has expressed the desire to “get rid of Dodd-Frank” and more generally expressed the need to relax excessively tight regulation. Easier regulation would also be supportive of higher rates from both a macro perspective (higher credit multiplier) and flow perspective (less regulatory driven demand for safe assets).
  • Third, Trump has stated his intention to change the Fed’s leadership. Yellen’s current term ends early 2018. At the moment, she appears unlikely to resign. It is also unclear who would be her successor. The thinking is that the new leadership would be less dovish, although that could change over time. While the repricing of monetary policy may be latest driver of higher rates to take hold, the risks are tilted towards a less dovish Fed beyond 2017. The combination of tighter fiscal policy, tighter regulation and aggressive monetary policy in DMs was the perfect recipe for a depressed term premium and low core rates. The market has been underpricing the potential for a change in the policy mix given that: (a) further monetary policy easing has reduced marginal benefits, (b) the fiscal multiplier is likely to be high in the context of low real yields and relatively constrained credit conditions, (c) the political environment and (d) most of the key new regulations have been implemented. A Trump presidency significantly increases the likelihood of a rebalancing of the policy mix. This would represent a structural change from the post crisis norm and should result in higher term premia.
  • Finally, the move towards more protectionism is akin to a negative supply shock which increases trade barriers. This should lead to higher inflation and lower growth. Such a combination is on balance bearish for bonds as the negative correlation between inflation and growth would not justify their current negative risk premium. The key risk to this view would come from increased geopolitical uncertainty that could be triggered amongst others by an aggressive approach to trade negotiations. This risk is difficult to assess. However, following Trump’s acceptance speech, it seems less relevant for now than the other four factors mentioned above.

What is DB’s trade recommendation on this “Bigly” rates repricing?

We maintained last week our bearish rates bias despite the risk posed by the US election. Market pricing was benign relative to either a Clinton (front-end sell off) or Trump (long-end sell off) scenario. As  discussed above, there is no reason to change this view. We thus maintain the strategic term premium trade in the US (5s10s steepener with a 17% short in 2s) and the short Dec-17 eurodollar to reflect the potential repricing of monetary policy. We also maintain the long JPY 2Y as a hedge against risk off.

Just keep an eye on the dollar: once it moves too high, and China pukes as the Yuan crashes forcing China to liquidate a big dump of Treasuryues, accelerating to surge in yields, all bets are off.

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