2014, 2015 and 2016 all began with sizeable rate hike expectations, only to be dashed as the data disappointed. However, the famous last words “this time is different” can be applied in this case.
The Effect On Bonds
Bond yields reflect changing expectations of inflation. Higher price levels are typically followed by a bond sell-off because the fixed coupon received loses to its purchasing power in an ever-expensive environment.
Equally, the stock market would likely take a dive due to higher borrowing costs which, in turn, squeezes margins. Furthermore, higher discount rates on corporate cash flows and the increasing fear of central bank intervention would also contribute to such a fall.
President-Elect Donald Trump has outlined the need for a looser fiscal stance in the form of increased infrastructure expenditure. Such a policy can be funded in a variety of ways. The first is to delve into the national treasure chest, although it is currently empty and, in fact, deeply negative.
The second option is to issue the standard 30-year Treasury, which would impact the bond market considerably. Demand would be strong given global alternatives hovering around 0% for most developed economies.
The third option would be to issue infrastructure bonds although the difference here is that they would not be sold to the public, but to the Fed directly. That way inflation would not be impacted in the usual fashion.
The Fed Taking Action
Current market expectations assume the Fed will need to hike rates if government spending is cranked up to curb inflationary pressures. The difference with infrastructure bonds is that the Fed may not have to hike rates if such a fiscal policy is deployed. This would have radical consequences for existing yields because, of late, they have risen on the back of increased inflation expectations. One could see a re-rating, given the worldwide hunt for returns.
In such an environment, it is worth considering the possible direction of the major currencies. The dollar has rocketed on the back of increasing rate hike expectations, but if infrastructure bonds were to be Washington’s desired route, the Fed would not need to lift rates on the back of higher expectations of inflation. Rather, they would either do very little, status quo you might say, or they would adjust depending on the strength of the labour market.
Headline unemployment in the US is very low, but inequality is rising between the people with and without a degree. However, a Republican Chair of the Fed could change all that, something that would probably be accompanied by a tighter stance of monetary policy.
The dollar will strengthen irrespective of domestic plans, but the infrastructure method has the potential to curb the dollar ascension due to a slightly dovish Fed.
The devil is often in the detail, and the form of financing is a crucial aspect to portfolio returns, and thus expectations of future returns. Time will tell if Trump can deliver inflation and if he can get the perfect opportunity set for equity markets (moderate to low inflation) a slightly dovish Fed may lead to growth in US output.
The odds are certainly in his favour.