The post-crisis environment in the rich world has been marked by deflationary pressures and an unprecedented demand for debt – what more and more observers are calling a bond bubble. A week ago, there seemed to be little end in sight. Then Donald Trump won the U.S. presidential election. Judging by market reactions since Trump's victory early Wednesday morning, inflation expectations are rising, and bond yields are climbing as investors price in the new reality.
Factors the markets must now consider include Trump's promises for fiscal stimulus, his mostly-consistent hostility to monetary stimulus, his potential to empower like-minded figures in other rich-world democracies, and his reputation as a risk-taker.
How Did We Get Here?
The deflationary bond bubble environment that prevailed until Wednesday morning traces its origins to the financial crisis. After a wave of taxpayer-funded bailouts, governments and the electorates they answered to lost any willingness to stimulate their economies through fiscal measures.
As fiscal austerity reigned, however, central banks picked up the slack in order to rekindle the developed world's animal spirits. They slashed interest rates to near-zero in the U.S. and below zero in Europe and Japan. At the same time, they embarked on a bond-buying spree using freshly printed money, betting on an unconventional policy known as quantitative easing.
At the same time, deepening trade links among the world's economies depressed prices, as did technological developments and a tendency to save among an aging population.
In a report from October, Bank of America Merrill Lynch (BAML) argued that "quantitative failure" had set in. The unprecedented measure of charging lenders and paying borrowers had only led investors to pile into cash, resulting in "excess liquidity." Forced bond-buying by central banks had resulted in a "buy what central banks buy" mentality, driving bond prices even higher and yields even lower.
The beneficiaries, according to BAML, were rich individuals and large companies who could borrow cheaply. But political weariness and fading returns have signaled the peak of deflationary policies, the bank argued in October, leading to a shift from monetarism to Keynesianism, globalization to protectionism, and Clinton to Trump.
Part of that "big rotation" is a shift away form bonds, towards commodities, as well as a shift away from deflation, towards inflation.
TIPS, Treasuries and Commodities
Those predictions have proved prescient – and not just because Trump won despite the conventional wisdom. The Republican's victory has seen a spike in inflows to Treasury Inflation Protected Securities (TIPS), the par value of which is linked to the Consumer Price Index (CPI). According to a report released by BAML Friday, rolling eight-week inflows to TIPS are the largest on record.
These inflows are a sign of rising – or spiking – inflation expectations, since Trump's protectionism is expected to lead to higher import prices and his fiscal stimulus is expected to heat up the economy. It is also likely that markets are pricing in his potential to lend credibility to other rich-world populists such as France's Marine Le Pen.
The bond bubble appears to have been punctured as well. Yields on 10-year Treasuries rose 30 basis points over two sessions to 2.15% on November 10. Meanwhile, 2-year Treasury yields rose less quickly, leading to a steeper yield curve (which can, in turn, be interpreted as a sign of rising inflation expectations). (See also, Understanding Interest Rates, Inflation and Bonds.)
There are a number of reasons markets might demand higher interest on U.S. debt in the wake of Trump's election. For one, a rise in deficit spending makes government debt a riskier investment, even if the chances of default remain negligible. The Committee for a Responsible Federal Budget (CRFB) estimated in September that Trump's policies, which include tax cuts, infrastructure investment and a potentially pricey border wall, will decrease tax revenue by $5.8 trillion over ten years, while the federal debt held by the public will rise to over 86% of gross domestic product (GDP), from 77% today. In absolute terms, that is $5.3 trillion above the level expected based on current law. The public now holds $14.3 trillion of the $19.8 trillion national debt.
It is also possible that markets have internalized Trump's comments in May that indicated he would repay less than the full amount the U.S. had borrowed. While his statements were unclear, and he denied he was "talking about with a renegotiation," he argued, "you can buy back at discounts, you can do things with discounts," and, "I would borrow, knowing that if the economy crashed, you could make a deal." (See also, The Risks of Sovereign Bonds.)
As BAML points out in its note Thursday, however, a "bad" rise in rates – one based on fear – is not the only possibility. Trump could also usher in a "good" rise in rates, one that enables savers to collect interest on their deposits, for example. Trump's comments on the Federal Reserve's monetary policy have not been consistent, but he has mostly been hostile to the low-rate regime overseen by Janet Yellen (who he has accused to being beholden to Democratic politicians).
Trump could replace Yellen with a more hawkish Fed chair. If he follows through on promises of fiscal stimulus, he could remove some of the burden of stimulating the economy from the Fed and place it instead in politicians' hands, now that voters have demonstrated an increased appetite for fiscal stimulus through tax cuts and infrastructure investment.
As the winds shift, commodities are already beginning to benefit. Following the rout that took hold in mid-2014, commodities appear to have bottomed out and begun to recover. Trump's victory appears to have accelerated the rally. (See also, How Will Trump's Victory Boost Silver?)
You Never Know
It remains to be seen whether this thesis will play out. Central banks and free trade are deflationary forces Trump has the potential to curb, but – as BAML points out – he has relatively little power to keep technological innovation from depressing prices or to reverse the demographic trend towards an older population (a trend that arguably improved his electoral prospects). Also, while deficit spending might boost the economy and lead to inflation, booming sovereign debt has the potential to be disinfaltionary as it creeps up against GDP.