Investors see inflation, economic growth under Trump as bond yields rise

Long-term US interest rates, as measured by the 10-year Treasury note yield, made a record low earlier this year. Following the surprise results of the British referendum (i.e., Brexit) and the fact that large swaths of the sovereign bond market were actually in negative territory, the 10-year Treasury note closed at an all-time low yield of 1.36 percent on July 8.

Bond yields fall as prices rise, vice versa. Since then, yields have moved significantly higher, but the sharpest moves have occurred after the U.S. presidential election. To wit, the yield on the 10-year Treasury note edged up to 1.85 percent by Election Day, but has soared to as high as 2.49 percent intra-day on Dec. 1 only to close at 2.45 percent.

{mosads}Yields have drifted a bit lower since then. What is the behind the market move?

The initial catalyst for the reversal of the downturn in yields was less concern that Brexit would have meaningful long-lasting effects on the global economy. A couple of strong U.S. monthly employment reports also helped to mitigate what had been renewed recession fears.

In the process, the U.S. Treasury market began to lose some of its safe-haven appeal. Money started to move out of the government debt market into other higher returning instruments, such as stocks and junk bonds.

The rise in yields from July through early November was relatively orderly — it was a grinding increase. However, the sharper jump in yields following the election has been more noteworthy.

It is clear from the Treasury market that investors believe that President-elect Trump’s economic plans will lead to a faster rate of economic activity and likely higher inflation. This is seen in the fact that the real interest rate, which can be measured by looking at the Treasury’s Inflation Protected Securities (TIPS), has jumped over 20 basis points, or roughly one-third of the increase in yields, since the election.

The remaining two thirds of the increase has been due to rising inflation expectations, a function of stronger anticipated economic growth next year and beyond.

 

It is no wonder that this has been corroborated in the short-term futures market, which has increased its expectation of monetary tightening over the next year by 50 basis points since the election. Ostensibly, the Federal Reserve (the Fed) would not be raising interest rates except in response to stronger growth and inflation.

How high could the yield on the 10-year Treasury note go? It depends on several factors, not the least of which is how much the Fed ultimately raises interest rates and what monetary policymakers decide to do with their balance sheet.

During the financial crisis, the Fed purchased large amounts of government debt, over $3 trillion worth of securities in its quantitative easing programs. The pace at which the Fed pares down its balance sheet (if it does so at all) will be an important determinant of Treasury yields going forward.

Based on our projection of 3 percent real GDP growth next year, the yield on the 10-year Treasury note should move up to 3 percent next year and closer to 4 percent by year-end 2018 if the Fed raises short-term rates as we expect.

There is a risk that rates could increase much more, as it is quite plausible that economic growth will overshoot our projections. On the flip side, if the 10-year Treasury yield does not increase as much as we expect, the likely culprits will be the dollar or overseas markets.

As the economic outlook continues to improve, the dollar could appreciate substantially. The Fed might choose to dampen the strength of the dollar by raising rates relatively slowly in order to avoid exacerbating the international trade deficit.

Moreover, next year’s elections in France, Germany and the Netherlands pose considerable risk of political instability in the eurozone, as populist, euro-skeptic parties are expected to make significant gains. If the situation in Europe devolves to the extent that the future of the currency union (the euro) is at risk, international investors might once more turn to the Treasury market as a safe haven, thus suppressing Treasury yields.

While these risks cannot be ignored, our base-case scenario is that Treasury yields will continue to rise as the U.S. economy picks up steam.

 

Joseph LaVorgna is the managing director and chief U.S. economist for Deutsche Bank Securities.

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