The bond market and dollar index have begun to sensitize to the potential implications of another Trump victory. The ten-year yield has increased by 55 bp. after the Federal Reserve cut interest rates in mid-September.
Americans who have been waiting for rate cuts are once again battling with their mortgage rates starting with the digit “7” as they tend to be priced at the long-term end of the yield curve. The shape of the curve is indicative. While the OIS (Overnight Index Swap) futures strip is curbing expectations for rate cuts from the Fed this year, the spread between the yield on 2-year versus 10-year US Treasuries tends to widen.
Notably, at the beginning of September the yield curve was still inverted, while it now registers a positive slope of 15.5 bp. – although the curve has shifted higher. Amazingly, the 10-year vs. 30-year spread hasn’t widened at all since the Fed cut rates.
What does this tell us? In short, markets expect fewer rate cuts in the near term, with inflation higher than what we’ve been used to in the recent past. Why is this happening? As Donald Trump’s chances improve, markets are repricing assets to reflect the state of Trump’s political world.
Trump himself is not fiscally disciplined: he favors sweeping tax cuts and tariffs, which are inflationary, but a Trump victory is not the only concern in the bond market.
Democratic candidate Harris is not a fiscal “hawk”, while the worrying fact is that the global debt has increased to unimaginable heights as states will face more and more challenges (expenses for interest, demographics, health, national defense).
Rational Expectations Theory
Price action looks like a win for Rational Expectations Theory. The concept of low but stable inflation targets is based on the idea of ’nominal rigidities’. Essentially, it is argued that some prices in the economy are “sticky” and that markets do not self-equilibrate in the way classical economists suggest.
- An example of this may be the decline in home sales volume in the US as sellers refuse to adjust price expectations to reflect prevailing economic conditions.
- Another example could be the proposed 10% cut in the wages of Volkswagen workers in Germany, which is due to the fact that Europe is losing the trade war with China.
In both cases, market offers (for homes and jobs) remained flat and unadjusted to the cold economic reality. The bid/ask spread widens and trading activity stops.
How do the neo-Keynesian economists who dominate central banks and national treasuries solve such a problem?
They grease the wheels of the economic machine by creating enough inflation that supply prices rise enough to match selling prices.
We may get these kinds of thoughts when UK Chancellor Rachel Reeves delivers her first budget. In a document that is unlikely to hold any surprises, Reeves is set to redefine how the UK measures debt so it can borrow more to “invest”.
UK debt to GDP already exceeds 90% – the point at which the Keynesian multiplier falls below one.
In layman’s terms, this means that for every additional dollar the government spends, GDP increases by less than a dollar, thus making stimulus measures to borrow and spend self-defeating as debt grows faster than GDP.’
Cycle of destruction
How can a state escape from this cycle of destruction?
The options are bankruptcy or austerity. We can rule out austerity as something no government is brave (or stupid) enough to propose seriously, since previous attempts by George Osborne and Wolfgang Schaeuble have been disastrous.
In the case of bankruptcy, countries that cannot issue their own currency are hard-bankrupted, while governments that issue sovereign currencies can afford to secretly go bankrupt by devaluing their currencies.
This is the scenario of financial repression under which those bondholders finance the fiscal waste by holding securities with negative real returns.
Under this scenario, the smart money gets out of bonds and into real assets that provide a hedge against inflationary pressures. (At the time of the Greek default, Greek bonds were derisively referred to in financial markets as “ouzo bonds” – a clear allusion to the bond’s yield, which, at 40%, was numerically comparable to the ouzo content of Greece’s national drink alcohol.)
With the S&P500 up more than 22% YTD and long-term yields on the upswing, is this the future markets are now envisioning in what is starting to look like a debt crisis?
