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Authers’ Note: Trump and the bond market

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Donald Trump has been remarkably consistent in his first month in office. As he reminded everyone at his press conference on Thursday, he has done what he said he would do. But on the same day came one clear-cut instance where he has changed his mind — on the stock market.

This is what he tweeted on Thursday.

It is true that stocks are doing very well at present, although “longest winning streak in decades” is hugely overstating it. But he may well not have benefited much from this himself. Sadly, we do not have a great grasp over exactly what is in the Trump investment portfolio, but he did offer this nugget of information to Fox Business News in August last year:

“I did invest and I got out, and it was actually very good timing. But I’ve never been a big investor in the stock market.”

Unless he got back in the day before the election, that may no longer look like such good timing. And he went on to make some comments that suggest that a strong stock market may not necessarily be a credit to the administration in charge.

Mr Trump plainly set out his fear that stocks were only performing well under President Obama because of “artificially” low interest rates:

“Interest rates are artificially low. If interest rates ever seek a natural level, which obviously they would be much higher than they are right now — you have some very scary scenarios out there.”

He also said:

“The only reason the stock market is where it is is because you get free money.”

The view he was giving on Fox Business was extremely respectable. Stock markets in the US plainly benefited for years from exceptionally easy monetary policy from the Federal Reserve. With interest rates so low on fixed income securities, investors were effectively being dared or forced to buy stocks.

There is at least one intriguing hitch, however. The easy money world is not over. If we measure rates in real terms, subtracting the rate of inflation, then rates have by at least some crude definitions gone negative in the US. This is the 10-year Treasury yield with the current inflation rate subtracted from it:

That is a crude measure of real rates, although it does involve measures that are widely watched and cited. A better measure of long-term real rates may be the yield on inflation-linked bonds. Paul Krugman of the New York Times recently posted this chart to show that real rates, after a big initial reaction to the election, have scarcely budged:

On this measure, note, real interest rates were actually negative when Mr Trump was talking about “free money” last summer, and they remain remarkably low now.

Mr Krugman, a staunch liberal, is presumably not Mr Trump’s favourite reading, but his judgment on the market is interesting:

“I still think that markets are too sanguine. But the truth is that they haven’t moved nearly as much as the hype suggests, so the case for either a huge Trump effect or a huge Trump bubble is a lot weaker than you might think.”

The first phase of the “Trump Trade”, immediately after the election, saw an emphatic global bet on reflation. Bond yields went up, stocks went up, commodity prices went up and so on. That lasted a little more than a month, and then we went into a holding until the inauguration.

We are now into a second phase of the Trump Trade, which involves again a clear-cut belief in reflation from the equity and commodity markets, but a much more equivocal stance from the bond markets. Long-term inflation break-evens have risen to 2 per cent in the US, but stuck there for a while. Ten-year bond yields rose to 2.6 per cent briefly, but have since largely stayed below 2.5 per cent.

This is despite a noticeable rise in inflation. The tax plan rollout, mentioned by Mr Trump, looms as being hugely important. As it stands, equities are behaving as though a big stimulus is a given. Low rates give even greater reason to buy stocks. The bond market is priced on the assumption that there is real reason to question how much of a stimulus the administration will eventually deliver, and hence a real need to question whether the Fed will need to raise rates as much as it says it will.

In an interesting blog post, Krishna Memani of Oppenheimer Funds suggests that there is a disconnect. 

“Further, US Federal Reserve chairwoman Janet Yellen basically threw in the kitchen sink for hawkishness — with talk of tightening, balance-sheet moves, etc — and we had a very strong inflation number, yet the 10-year barely broke through 2.5%.

“In other words, the US bond markets are watching and waiting but far from convinced that the regime has changed. Equity prices, on the other hand, have already assumed that the regime has indeed changed. There is a bit of a disconnect there.”

I find his conclusion to be very reasonable:

“Yet there’s a challenge: The probability of radical policy prescriptions and fiscal expansion is high, but from what I can gather from the vacillations coming out of Congress, the trend is lower rather than higher. To some extent, the bond markets are incorporating a bit of that scepticism about policy prescriptions and their net impact on the outlook for regime change. Equity markets, on the other hand, continue to incorporate a significantly higher probability of radical policy prescriptions happening — and soon. There is a clear market divergence that needs to be resolved.

“So, there’s nothing significant investors can do right now. But it would seem to me that if one had an extended position or had gains to protect, reducing downside risk somewhat would be prudent at this juncture.”

If the bond market proves right, then the confidence and optimism that the president noted in his tweet could soon disappear. He may yet live to be less enthusiastic to tweet about the stock market. For the time being, the support he noted last summer from low interest rates remains in place, and equity investors are enjoying themselves.

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