Why the divergence between bond and stock markets bodes ill for ‘Trumpanomics’
Bond investors fear that Trump’s protectionist and nationalist agenda could offset any economic gains from tax cuts and deregulation
Global stock markets have been sending an unambiguous message since Donald Trump unexpectedly won the US presidential election in November, and it is becoming louder and clearer by the day.
For equity investors, particularly in the US, the trifecta of tax cuts, deregulation and infrastructure spending which the Trump administration has pledged to deliver is a game-changing development which will jump-start America’s economy, providing a major fillip to corporate earnings.
Last Wednesday, the four main US equity market indices achieved their latest ‘Grand Slam’ of record highs, led by financial stocks which would benefit the most from Trump’s plans for aggressive deregulation and, crucially, a faster pace of monetary tightening by the Federal Reserve.
The benchmark S&P 500 Index, which has shot up 11.5 per cent since Trump’s victory, has risen for six straight weeks, turbocharging the initial public offering of Snap, the owner of Snapchat, the popular internet messaging service, which, in its first day of trading last Thursday, was valued at a staggering US$28.3 billion.
The message from bond markets, however, is a very different one.
While there has been a dramatic repricing of US monetary policy over the past week – the odds of a rate rise at the Federal Reserve’s meeting on March 14-15 surged to more than 90 per cent at the end of last week (up from 40 per cent the previous week) due to a flurry of hawkish comments from Fed policymakers – this has little to do with expectations of significantly stronger growth in the years ahead.
Although the policy-sensitive two-year US Treasury yield has risen 45 basis points since Trump’s victory (with nearly a third of the increase occurring in the last week) and forward interest rates have crept up, this is almost entirely due to the rise in inflation, with the Fed’s preferred measure of consumer prices now just a tad below the central bank’s target of 2 per cent.
In stark contrast to equity markets, bond markets are fairly pessimistic about the longer term outlook for growth.
This is particularly evident in the US bond yield curve, which compares the interest rates of bonds with differing maturity dates and is used to predict changes in economic output. The gap between the yields on 30-year and two-year Treasury bonds currently stands at just 170 basis points, not that much higher than the nine-year low of 140 basis points struck as recently as last August. Even the benchmark 10-year Treasury yield has fallen to just under 2.5 per cent, slightly lower than in mid-December and more than 50 basis points below its level at the start of 2014 when the Fed was just beginning to wind down, or taper, its quantitative easing programme.
Part of the reason why US bond yields remain low despite a much more hawkish Fed and Trump’s plans to ignite growth is the downward pressure on borrowing costs being exerted by the aggressive quantitative easing programmes in Japan and Europe.
Even in the face of the recent flurry of stronger data on growth and inflation in the euro zone, Europe’s single currency area still accounts for one third of the US$8.2 trillion global stock of negative-yielding government bonds, according to JPMorgan. Germany, whose economy grew by nearly 2 per cent last year and where headline inflation has surged to 2.2 per cent (above the European Central Bank’s 2 per cent target), accounts for nearly 30 per cent of the stock of negative-yielding debt in Europe.
Another, more important, reason why US bond markets are diverging from equity markets is structural. A global “savings glut”, stemming partly from unfavourable demographics and current account surpluses in many large developed and emerging markets, is fuelling demand for safe assets such as Treasuries, keeping yields low.
Yet the most worrying reason is that bond investors strongly doubt whether Trump’s economic policies will significantly raise America’s long-term growth potential.
This is partly because of fears that the protectionist and nationalist part of Trump’s agenda could offset any potential economic gains from tax cuts and deregulation. “Curbing immigration and sending back undocumented workers would tend to reduce US labour force growth and thus potential output growth further,” notes Pimco, a large asset manager.
While the bleak message from bond markets is, paradoxically, buoying equity markets by keeping bond yields at relatively low levels, the divergence between the two asset classes bodes ill for ‘Trumponomics’.
If the bond market is right – and it invariably is – equity investors are getting way ahead of themselves.
Nicholas Spiro is a partner at Lauressa Advisory