The recent political developments, particularly the rise of Donald Trump, have given a boost to a struggling bet in the bond market. However, the ultimate catalyst for this bet to truly take off lies with the Federal Reserve. Trump’s proposed policies, such as tax cuts and higher tariffs, have led to increased inflation expectations and concerns about the US economy, particularly if the Republican party gains control of Congress. This so-called “Trump trade” has also benefited investors who have bet on a return to normalcy in the bond market, as short-term yields have surpassed those on longer-term debt. But for this trend to gain traction, the Fed must step in and lower their target interest rate, which would likely result in a sustained decline in short-term yields.
“The Federal Reserve’s decision to lower rates is a significant factor in causing the yield curve to steepen,” explained John Madziyire, a senior portfolio manager at Vanguard. “Additionally, on the political front, the possibility of a sweep in November puts fiscal deficits in the spotlight.”
In the past two years, the bond market has been experiencing what is known as an inverted yield curve, where the yields on two-year bonds have been higher than those on benchmark 10-year bonds. Many have been speculating on a reversal for almost as long, but without much success. However, that appears to be changing.
On Monday, following the assassination attempt on Trump over the weekend, the yield on 30-year Treasuries surpassed the rate on two-year notes for the first time since January 31. Investors are now considering how the renewed energy among Republican voters may impact the outcome of the House and Senate elections, especially as the party’s convention gets underway. The yield curve slightly flattened on Tuesday.
“We must exercise caution as there is a significant amount of time between now and the election, and circumstances can change rapidly,” stated Victoria Fernandez, the chief market strategist at Crossmark Global Investments, during an interview with Bloomberg television on Monday. She emphasized that if the current trend of increasing market volatility, instigated by President Trump, continues, it will largely depend on the outcomes of the convention and the Trump campaign’s ability to attract moderate voters.
With this situation unfolding, investors are now closely monitoring the Federal Reserve’s actions and their potential interest rate cuts for the remainder of the year. This is seen as a critical factor in returning to a more typical Treasury yield environment. A steeper yield curve, which indicates expectations of imminent rate cuts by the Fed, has been limited by the central bank’s previous indication of a prolonged period of high interest rates. Consequently, this has restricted the extent of a significant decline in yields.
A year ago, the central bank raised borrowing costs to a high of 5.5%, but now the outlook is more positive. Inflation is finally showing signs of cooling down, and if progress continues, the Federal Reserve is expected to lower interest rates by September. Traders anticipate a decrease of about 1.5 percentage points over the next year.
During a speech on Monday, Fed Chair Jerome Powell acknowledged the progress made in controlling inflation but did not provide specific details about future policy changes. He reiterated that a sudden weakening in the labor market would prompt rate cuts.
On Tuesday, traders will closely watch retail sales data to gauge the health of consumers and determine the potential path of the Fed’s policy. Currently, the market is fully pricing in a quarter-point rate cut in September, with a 60% chance of a third cut by December. Economists at Goldman Sachs Group Inc. even suggest that there is a strong rationale for the Fed to cut rates as early as their upcoming meeting this month.
The yield curve between two-year and 10-year bonds has narrowed to 25 basis points, down from a high of 51 basis points in late June. Bloomberg strategists suggest that as the likelihood of a Trump win increases, investors may anticipate the implementation of major tariffs and subsequent price increases. This could favor a bear steepening trade, where long-term yields rise faster than short-term yields. However, there is no guarantee that short-term rates will remain anchored as investors scale back bets on Federal Reserve rate cuts. Vineer Bhansali, founder of LongTail Alpha, has taken a steepening position through derivatives structures to offset the costs of the trade. He also notes that economic data and the Federal Reserve’s outlook have played a significant role in the steepening trend, alongside the increasing odds of a Trump victory.
According to Bhansali, there is a strong desire for rate cuts from Powell, which is driving the short-term market. Additionally, it seems that the market believes there is little chance of anyone competing with Trump in the long-term.
The expensive nature of a steepener trade and the high cost of funding that position has led to a cautious approach from traders in recent months. This is because they have been burned in the past on short bond trades. As a result, investors may want to ensure that the dominance of the Trump trade is confirmed before taking a short position in fixed income again, as stated by Steven Englander, a strategist at Standard Chartered Bank in New York.
Bhansali remains undeterred, noting that the steepener strategy has not been performing well recently but has shown promising behavior this month. He believes that once the spread between the two-year US note and 30-year Treasury bond starts moving, it will continue to do so significantly. Bhansali expects the spread to turn positive and potentially widen by up to 2 percentage points.
However, for some market participants, the return to normalcy is not solely attributed to Trump. They believe that the biggest market movements are yet to come, driven by factors such as slowing inflation, a slower labor market, and the Federal Reserve’s actions. They argue that the assumed inflation resulting from a Trump presidency is not as evident as many believe.
This article was written with assistance from Matthew Burgess, Ye Xie, and Nicholas Reynolds. It also includes the latest market developments in the sixth paragraph, updated prices in the 12th paragraph, and insights from a Bloomberg strategist.