“Sometimes I’ve believed as many as six impossible things before breakfast”
The Queen, “Alice in Wonderland” (Lewis Carroll)
Well well well – what a week that was!! First an unexpected (at least to most of us on the European Investment-Grade Fixed Income desk) winner in the U.S. Presidential election, and then a significantly different market reaction from what many investors had expected in the event of a Trump victory. The initial market reaction was in line with what we had expected, but the massive turnaround in performance from 6am European time on Wednesday morning was unexpected, and left many investors scratching their heads and looking for explanations. But eventually things became somewhat clearer, and here is our attempt to analyse what developments in the U.S. might mean for European bond markets.
1. Why have bond yields risen?
Bond markets are reacting to the increased likelihood that, having achieved a clean sweep of the Presidency, the Senate and the House of Representatives, Donald Trump can enact a fiscal stimulus package. This should boost growth and in turn inflation. Protectionist trade policies and tariff impositions could also boost U.S. inflation. We have talked in the past about the lack of any inflation premium in bond yields – last week the markets began to price in more inflation risk premium, especially in longer-dated bond yields. A fiscal package suggests increased spending, potentially bigger deficits and perhaps more bond issuance, which is another upward force on bond yields.
2. Why should this affect European bond yields?
Mainly through a cross-market valuation comparison. If 10-year U.S. bond yields rise by 40bps compared to European bond yields, that makes them more attractive to investors. Therefore, we historically have seen European bond yields rising in sympathy with rising U.S. yields, although perhaps not by as much. But European investors may also start to factor in higher inflation in Europe as well, especially if the Euro weakens, like what happened last week.
3. How could Trump’s victory affect European politics?
Amongst the first to congratulate newly elected President Trump were some of the most vocal leaders of anti-austerity and anti-EU parties in Europe. Marine Le Pen in France and Geert Wilders in the Netherlands were two who saw this as an affirmation that anti-immigration policies are a popular vote-grabber. And let’s not forget that Europe has another big political event in early December, when the Italian electorate vote in a constitutional reform referendum. There’s a significant danger that many voters treat this as a chance to express their disaffection with Prime Minister Matteo Renzi and economic conditions, rather than a vote on reforms. But it could be the area of monetary and fiscal policy where we see the biggest impact. Should Trump’s planned fiscal boost turn out to lift growth and employment, European leaders may see this as a means of addressing the ineffectiveness of monetary policy and the consequent rise of vox populi. In the past, this blog has noted Spain’s and the UK’s move towards more relaxed fiscal stances. Whilst there is less room for an expansion of fiscal policy in Europe, we think looser fiscal policy globally could be one of the big themes for 2017.
4. Trump has been openly critical of the Fed and Chairperson Janet Yellen – is there any read-across to European central banks?
During the first Presidential debate, President Elect Trump was openly critical of the Fed and Chairperson Yellen, accusing them of keeping rates too low for political reasons. There are currently two vacancies on the Fed’s board that Trump will fill once inaugurated, giving him a potential say in how the Fed conducts monetary policy. Likewise, in Europe, central banks have been attracting increased criticism for their actions in recent years. Some German politicians and Bundesbank members have been forthright in expressing their displeasure at the ECB’s ultra-accommodative monetary policies. This was recently ratcheted up a notch with UK Prime Minister Theresa May’s attack on the Bank of England. The independence of central banks is a relatively new phenomenon – bond markets would probably react negatively to any actual or perceived loss of independence.
5. Are there any implications from Trump’s election for the ECB at their forthcoming meeting on 8 December?
We really don’t think so. Given the relatively benign market reaction to Trump‘s victory, we doubt that the ECB will be too concerned about the economic backdrop as they go into their meeting. Yes – financial conditions have probably tightened as a result of higher bond yields, but if the Euro continues to depreciate that will help offset some of the rise in bond yields. There are probably two things that could give the ECB food for thought heading into their meeting – if bonds yields were to rise significantly between now and then (similar to the sell-off seen in April/May 2015) or, as currently seems likely, the Italian referendum gets defeated and causes a major widening of the spread between Italian and German government bond yields. Ahead of the referendum, we have decided to move to a neutral stance on Italian government bonds compared to our previous overweight stance. We believe that the ECB should announce an extension of their bond-buying programme, but to signal a reduced level of bond purchases each month. This may put further upward pressure on European bond yields, and is a key reason why we prefer a short duration stance in German Bunds.
6. Are there any European countries that might be particularly affected by Trump’s proposed protectionism and tariffs?
In theory, the boost to U.S. growth from a fiscal plan should translate into opportunities for Europe and global exporters. However, that could easily be offset by difficulties arising from protectionist policies and imposition of trade tariffs. Any country that generates a higher-than-normal component of GDP from exports, or that runs a significant trade surplus with the U.S. is, at the margin, more at risk, and into this category falls Germany, the UK and Ireland. Attempts to persuade large U.S. multi-nationals to repatriate their overseas cash holdings could also affect countries perceived to have low corporate tax rates, again such as Ireland. It was interesting to note that Irish bond yields underperformed last week based, in part, on these fears.
Taken together, the above points reinforce a trend the European Investment Grade Fixed Income team felt had already been developing in markets – a transition from monetary stimulus to fiscal stimulus, a corresponding increase in inflation premia (and now term premia) that manifested itself in higher inflation breakevens, higher real yields, and ultimately steeper yield curves and higher nominal bond yields. Beware the danger of duration.