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“Trump Tantrum” Roils US Bond market


Nov 21, 2016

    Earlier this year, as government bond yields tumbled to all-time lows in the immediate aftermath of the UK’s June 23rd vote for Brexit, the value of sovereign debt with yields below zero percent – had ballooned to $11.7-trillion. Fixed income investors were confronted with stark choices. Many fund managers shifted into lower quality junk bonds in the hunt for juicier yields, others — including pension and insurance companies required to stick to better quality borrowers — plowed monies into longer-dated bonds. Until the US-elections on Nov 8th, the strategy had paid off handsomely, with government debt maturing in more than 10 years returning about +12%, year to date, outpacing stock markets in the US, Europe and Asia.

    One of the consequences of this ultra-low and negative interest rate environments was to force money managers further out on the yield curve. Yield hungry investors were gobbling up longer-dated bonds, with Argentina’s government among the chief beneficiaries. Exiled from international capital markets for more than a decade, Argentina attracted $18-billion of orders for a 30-year bond offering with a yield of about 8-percent. The US Treasury enjoyed strong demand for a 10-year bond auction — selling the notes with a yield of 1.76%, roughly half what it has had to pay on average since 2000. The fear, though, for the buyers of the longer-dated bonds is risk that yields snap sharply higher. A simple back of the napkin exercise, is that for each +1% increase in bond yields, a bond’s price will decline by a percentage of its duration. Bond yields fall when prices rise.

    The term duration has a special meaning in the context of bonds. It is a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. It is an important measure for investors to consider, as bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations. Generally, bonds with long maturities and low coupons have the longest durations. These bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing rate environment. Conversely, bonds with shorter maturity dates or higher coupons will have shorter durations. Bonds with shorter durations are less sensitive to changing rates and thus are less volatile in a changing rate environment.

    Since Mr Donald Trump’s shocking upset victory in the election for the US-presidency, investors have been dealt a stinging reminder of the risks of longer-dated bonds. There has been a tsunami of selling by panicked bond investors – who were caught absolutely flat-footed, and stuck with the biggest leveraged long bond positions in history, after years of front running the market-manipulating central banks. Donald Trump’s stunning victory for the White House -probably marks the long-awaited end to the 29-year-old Bull Run in bonds. A ten-day thumping wiped out more than $1.5-trillion across global bond markets worldwide, the worst two-week loss in decades.

    During the campaign for the US-presidency, Donald Trump hammered President Barack Obama for doubling the national debt from $10-trillion to over $20-trillion. But now, a Republican -led spending spree is coming, led by Donald Trump, who is riding to the White House, and a Republican Congress that looks likely to do his bidding. It’s a potential echo of the last time Republicans ran Washington, when then-Vice President Dick Cheney memorably remarked, “Deficits don’t matter.” Trump has big spending plans, but he doesn’t have the revenue to pay for it. A top Trump priority major spending on infrastructure and “rebuild” the US- military . Trump and congressional Republicans are also planning enormous tax cuts for businesses and individuals — with high-income households getting the biggest benefits.

    There is one major difference between the days of Reagan and modern America: – when Reagan came into power, the US’s debt to GDP was just 30%. It is nearly 100% now, as such Reagan had much more fiscal headroom than Trump does today. If Donald Trump intends to flex the fiscal lever, bond market vigilantes could return with a vengeance, making it increasingly expensive for him to do so. Traders are confident that major tax legislation will pass in 2017. Part of the reason for this confidence is the ability to pass fiscal legislation (addressing tax policy, certain types of spending, and the debt limit) with a simple majority in both bodies of Congress, avoiding the possibility of filibuster and the 60 votes needed to overcome such procedural obstacles. With 52 Republicans in the Senate and 51 votes needed for passage (including the Vice President as tie-breaking vote if necessary), this allows for Republican-authored tax legislation to pass without Democratic support.

    There is now a real risk of an onslaught of deficit-financed goodies — tax cuts, infrastructure spending, more on defense — all in the name of stimulus, but which in reality will massively balloon the US’s national debt. The non-partisan Tax Policy Center estimated Trump’s tax plan would increase the federal debt by $7.2-trillion over a decade. In comparison, the huge George W. Bush-era tax cuts cost less than $2-trillion. And that’s not counting the extra $10 trillion of debt the government will need to cover the rising cost of programs like Social Security and Medicare over the next decade, according to the CBO. Net annual interest costs alone are expected to almost triple by 2026.

    Not all of the promises Trump made on the trail will be enacted, of course, but even just a few would mean a flood of red ink. As such, bond traders are beginning to price in a “term premium” — or the extra compensation investors demand for taking on more duration — and an inflation risk premium – that are propelling bond yields upward in the past few days. Trump’s plans for aggressive fiscal policy, the likes of which hasn’t been since before the Great Recession, have re-awakened the “Bond Vigilantes,” – referring to traders who sell Treasury bonds, in an effort to enforce fiscal discipline, by making it more expensive for the government to borrow and spend. “Trump-Economics” implies a likely faster pace of Fed rate hikes next year. Already, the yield on the US’s 10-year T-note yield has jumped +60- basis points higher since Election Day (as of early-afternoon trading), to close at 2.35% on Friday, as the bond market awakens from its induced coma.

    As such, bond investors are now demanding extra compensation for holding a longer dated bond, and are now worried about getting wrong footed by higher inflation and a tighter monetary policy than was in their earlier forecasts. Perhaps the investment that is most sensitive to changes in bond yield is Vanguard’s Extended Duration Treasury fund (ticker; EDV). This fund tracks the performance of an index of extended-duration zero-coupon U.S. Treasury securities (STRIPS) with maturities ranging from 20 to 30 years. For instance, a increase of +75-bps in the US’s 30-year T-bond yield has translated into a -19% loss for holder of EDV.

    With bond yields soaring, the pool of government bonds with a negative yield, which means investors effectively pay for the privilege of lending money, is in decline. According Fitch Ratings, $10.4-trillion of sovereign bonds had a negative yield at the start of November, down from $11.7-trillion in June.

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