Higher long-term rates may end the 30-year bond rally, say Stewart Brentnall and Mark Rider.
The reaction of financial markets to Donald Trump’s US presidential election win illustrated the opposing economic forces of the upcoming Trump presidency.
Initially there was fear and uncertainty, largely due to the potential reversal of trade agreements and a rollback of globalisation. But the focus quickly shifted to what positive changes Trump may make, including lowering tax rates, sparking a rally in sharemarkets.
This upbeat mood continued throughout November, with sharemarkets posting further gains and bond yields continuing their upward trajectory.
Finally, a shift to fiscal policy
Longer term, the Trump clean sweep opens the door to a US policy shift – from a heavy reliance on ultra-low interest rates to spending, job creation and earnings.
While it’s far too early to make a judgement on the scale or detail of President-elect Trump’s fiscal policy, some analysts believe the proposed corporate and personal tax cuts could see government tax revenue fall by about $US6 trillion (i.e. around one third of annual gross domestic product) over the next decade.
If that were to happen the US budget deficit could rise by about 3 per cent of GDP (as it did in the early 1980s under President Ronald Reagan) and government debt could soar to 105 per cent of GDP from its current level of 75 per cent of GDP.
While a re-weighting of policy support from monetary to fiscal policy is welcome, the potential scale of it has markets pushing bond yields higher on the prospect of more debt, stronger growth and higher inflation.
Headline inflation moving higher (%)
Sources: ANZ Wealth, Datastream
Why ‘Trumpflation’ is not a major concern
Trump’s expected stimulus would likely add to inflationary pressures, particularly in the United States. But that doesn’t mean we would suddenly end up with inflation being too high. There are a few key reasons for this:
- Higher inflation has been a stated objective of central banks, with core inflation in Europe and Japan still well below 2 per cent respectively.
- A stronger US dollar may help keep US inflation in check.
- The US manufacturing sector is only at 75 per cent capacity, well below the level at which inflation has gotten out of hand in the past.
The bond rally may be over
The rise in bond yields after the US election continued a shift that was already under way in response to easing deflationary forces. Trump’s election and expected tax polices just add to this backdrop.
We consider somewhat higher inflation and eventual higher long-term interest rates to be positive signs for the economic outlook. However, it is increasingly looking like the 30-year bond rally has come to an end.
This may put some eventual pressure on fixed-income asset returns which have delivered exceptional performance over the past 20 years.