Markets risk undervaluing the Trump effect

It is a story of the markets against the US Federal Reserve — and so far, the markets have been on the right side of the call. Bond market movements have this year proved a better guide to potential shifts in benchmark rates than has the Fed’s official range of projections.

But as Donald Trump prepares to take power amid expectations that the Fed will next week raise benchmark rates, the question is whether the markets are wrong to be confident that rates will remain relatively low.

Several analysts and experts argue that the markets have failed to factor in the full implications of Mr Trump’s drive to switch from monetary to fiscal stimulus — and that an increase in the federal funds rate next week could be just the beginning of a sustained series of rises over the medium term.

“The market is not pricing in a level of aggressive hiking that the rhetoric in Washington is suggesting,” said Ian Lyngen, strategist at BMO Capital Markets, who added that with Fed chair Janet Yellen “leaving in the beginning of 2018 and two empty seats on the board to be filled, Trump will surely seek to leave his mark on the Fed and we have to assume it will lead to a more hawkish Fed composition”.

John Brady, managing director at RJ O’Brien, a futures broker, is concerned the bond market is being too complacent. He says there could be at least three further rate rises next year, taking the federal funds rate towards 1.5 per cent as Mr Trump pushes a fiscal stimulus through Congress. “There is a risk that the market then starts pricing in more tightening from the Fed,” he said.

For 2016, by contrast, market scepticism about the Fed’s willingness to raise rates has been broadly proved right.

When the Fed raised rates by a quarter percentage point in December last year — the first such increase since the financial crisis — the central bank signalled that more increases were to come. That was the message continued throughout this year of the “dotplot” published after Federal Open Market Committee meetings, which sets out members’ expectations of further rate rises. The markets have not been convinced, with interest rate futures prices suggesting no such series of increases and dotplot estimates have eased during the year.

The Treasury bond market together with the resurgent dollar and a record high US share market, has nevertheless been profoundly affected by Mr Trump’s election. Expectations that rates will increase have inflicted a punishing drop on bond prices.

At a current yield of 1.10 per cent, the policy sensitive two-year Treasury has risen towards its highest level since April 2010, when investors assumed there would be a robust recovery in the economy.

But the disparity in expectations with the Fed remains. According to the current dot plot, the funds rate should rise from a range of between 0.5 per cent and 0.75 per cent after Wednesday’s meeting to a band of between 1 per cent and 1.25 per cent by the end of 2017. By late 2018 it should approach 2 per cent.

By contrast, the bond market remains confident that the pace of tightening will remain glacial over the next two years. Interest rate futures prices suggest a federal funds rate of just over 1 per cent by late 2017 and a level of 1.5 per cent towards the end of 2018.

The market’s current equanimity over the pace of rate increases rests on the assumption that Mr Trump’s proposed fiscal stimulus will take time to pass through Congress and uncertainty whether his plans will ultimately boost the economy.

‘’If we see a tax bill before the end of June, I would be very surprised. The really substantive policy will take time to pass through Congress,” cautioned Jay Mueller, portfolio manager at Wells Capital Management.

Investors are also watching whether the president-elect’s fiery campaign rhetoric on trade and immigration translates into policies that hurt the US economy, reducing any upward pressure on interest rates.

But the bond market may need to adjust further to the prospect of fiscal measures elevating growth and the pace of inflation, a scenario that would prompt faster Fed tightening and higher Treasury yields.

Many argue that the prospect of the combination of a possible personnel change in the Fed and the end to Washington gridlock means markets may be seriously underestimating the Trump effect.

With both houses of Congress controlled by his party — a situation Barack Obama has not enjoyed since 2010 — the president-elect has a rare opportunity to make the political weather. As a result, even the Fed’s own expectations of rate rises may prove too conservative — a prospect bond markets could have to take on board.

“Fiscal policy is going to matter after being on hold for a number of years thanks to gridlock,” said Mr Mueller. “There is upside risk to the dot plot.”