We had a chat about Donald Trump’s tax cuts yesterday.
But there’s one important aspect of the cuts that I didn’t really cover.
The effect on the bond market…
We’ve been here before – and it wasn’t pretty
As John Plender points out in the Financial Times, Donald Trump’s tax cuts package represents a big loosening of fiscal policy. It might not be loosening in the areas that many people would want it to, but it all adds up to a bigger deficit.
Markets might not fret about the solvency of the US. Not when there are so many other candidates who would go bankrupt before America ever defaulted on its credit.
But looser fiscal policy, combined with a dovish central bank boss, adds up to a much more inflationary set of policies overall. Now might be exactly the wrong time for that approach.
Inflation looks relatively calm, and has been for a very long time. So it’s easy to feel – particularly after central banks have spent so much time courting it – that inflation is pretty much dead.
I wouldn’t be so sure. As hedge fund manager Hugh Hendry noted in his swan song a few months ago, there’s a very close parallel to today’s environment, and it’s one that Plender returns to in his column.
In the latter half of the 1960s, the US had extremely low unemployment – by 1966 the rate was below 3.8%. It also had very low inflation. Indeed, at the start of the decade, the country had been flirting with deflation, and by 1965, annual price inflation stood at just 1.6%.
As Plender points out, central banks were in no hurry to crack down. The Federal Reserve raised rates in late 1964, and again in late 1965. “Monetary policy was reactive rather than pre-emptive and conspicuously slow.” Very much like today, in other words.
Meanwhile, government spending was rising because of the Vietnam war and a campaign to end poverty by Lyndon B Johnson.
The upshot is that both fiscal and monetary policy were extremely loose, at a time of low unemployment, and low inflation. Something had to give.The “something” was inflation. (I wrote about this in more detail in September.)
By 1970, inflation was rising at just under 6% a year. And that was just the curtain-opener for a decade of disastrous levels of inflation. Between 1967 and 1970 alone, bond investors lost more than a third of their money in real terms (ie, after inflation).
The global bond bubble has already peaked
What might that mean for today? The global bond bull market looks to have reached its peak – in terms of yields, at least – nearly 18 months ago, in July 2016.
That’s when we saw some quite gobsmacking figures – huge chunks of the sovereign debt market trading on negative nominal yields, and all the rest of it. Meanwhile, the ten-year US Treasury yield hit a low of just below 1.4%.
The yield on the ten-year now sits at around 2.4%. At around 3%, I think we’d see most people acknowledge that the 35-year bond bull market was well and truly behind us.
The good news for bond investors is that with every step down in price and step up in yields, bonds become more attractive. Equities can fall pretty hard and fast once investors are rattled – the sheer number of risks involved make the outcomes harder to calculate.
With bonds – particularly government bonds – the range of outcomes is not hard to quantify. You’re going to get paid back – what you need to worry about is whether the money you get back is worth anything near what you originally loaned out.
A bond that doesn’t appeal at a yield of 2% becomes a lot more attractive at 5%.
The big problem though, is that central banks don’t sound as if they’re inclined to get ahead of inflation. And once it takes off, it’s a lot harder to get on top of. That in turn means that maybe that 5% bond doesn’t look so attractive, not if you think you might be able to get it at 8% in a few months’ time.
There’s also the question of bond market liquidity, and the effect on the much riskier parts of the market. So many parts of the credit market are now priced at levels that take little account of either micro risk (individual companies going bust) or macro risk (growth or inflation upsets) that when anything big happens, we’re bound to see some sort of dislocation.
As Plender puts it, “the impending Trump bear market in bonds will not want for excitement”.