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Bond market’s Trump scepticism feeds stock market euphoria

Donald Trump has been consistent in his first month in office. As he reminded us at his press conference on Thursday, he has done what he said he would do. But one issue he has changed his mind — on the stock market.

On Thursday he tweeted: “Stock market hits new high with longest winning streak in decades. Great level of confidence and optimism — even before tax plan rollout!”

It is true that US stocks are doing very well. They set more all-time records this week, and are approaching historically high valuations. But Mr Trump may not have benefited much from this himself. We do not know the full Trump investment portfolio, but he did tell 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 re-entered before the election, that may no longer look like good timing. The valid point he made was that stock valuations then owed much to low bond yields. Calling interest rates “artificially low,” he said: “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.”

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. Many, myself included, have fretted about what might happen if bond yields suddenly adjusted upwards.

After the election, 10-year yields rose some 70 basis points. This is a significant rise, but the fears of Mr Trump and others that higher yields would spark an equity sell-off did not come to pass.

But one vital caveat is necessary. Easy money is still here. Inflation is rising. If we measure rates in real terms, subtracting the rate of inflation, then rates have gone negative in the US. The latest US inflation rate slightly exceeds the 10-year Treasury yield.

A better measure of long-term real rates is the yield on inflation-linked bonds. On this basis, rates were negative briefly last summer (in the wake of the Brexit referendum), spiked to 0.7 per cent after the election (still not terrifyingly high) and are now at 0.5 per cent. Looking at nominal yields gives a similar picture. The 10-year yield reached 2.6 per cent briefly, but has since settled in a little below 2.5 per cent. A significant adjustment has happened, but in real terms money remains very easy.

So it makes sense to treat the latest equity rally as the second phase of the “Trump Trade”. The first phase, after the election, saw a big global bet on reflation. Bond yields rose, stocks rose, commodities rose. Then we went into a holding pattern until the inauguration.

In the second phase, there is a clear belief in reflation in equity and commodity markets, but a far more equivocal stance from the bond markets. That equivocal stance provides cheap money to keep the stock rally going.

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. Between the Trump administration and the Republican-controlled Congress, their logic reasonably goes, they cannot fail to come up with some big stimulative tax cut package.

The bond market is priced on the assumption that there is reason to question how much stimulus the administration will deliver, and hence a real need to question whether the Fed will need to raise rates as much as it says it will.

With inflation and wage growth rising from very low levels, and plentiful signs of optimism and economic strength, both viewpoints seem questionable.

This is particularly so given that Janet Yellen of the Federal Reserve this week spoke about as forthrightly as she could have done in favour of raising rates sooner and faster than many expect. As Krishna Memani of Oppenheimer Funds put it, she “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 per cent”.

He rightly finds a disconnect there. The two critical variables are the fiscal program that will finally pass, and the extent to which the Fed tightens in response. Investing in the US — and everywhere else, given the weight of the US in the world — will for the foreseeable future revolve around those variables.

If we get a big stimulus and the Fed stays dovish, the market is priced correctly. This is possible but unlikely. In the event of a big stimulus and a strong Fed response — possibly the single most likely outcome — we can expect bond yields to move a lot higher. Stocks would be at some risk. And if Mr Trump fails to deliver as much as hoped in tax cuts (unlikely but possible), while the Fed presses on with three or four rate rises this year, investors in both stocks and bonds should brace to lose money.

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