There have been many suggestions that the sell-off in government bonds in the US was overdone. The argument was that weakness was a result of Trump’s victory, but that it is far too early to know what Trump will do or the effect it will have. We have some sympathy with this view; the speed of the sell-off is asking some questions, particularly at the long end.
However, this analysis does seem to reflect some common behavioural influences. It ignores the starting point of valuation, and relies too much on the most salient explanation for price moves (Trump) without considering other possible causes. Could it be that fundamental developments in the US and investor perceptions of risk are playing a more significant role here, and that these could be lasting?
The US economy: Running hot…
Back in October, Janet Yellen discussed the possibility of running a “high pressure economy” with tight labour market to drive wage growth and consumer spending, which will in turn translate into renewed investment activity. This could mean more inflation and growth than we have been used to, which is traditionally bad for bonds. But how high is “high pressure” and how do we measure it?
The starting point is the labour market, first barometer of the economic activity. The recent trend has been very positive under a number of metrics.
Last week’s unemployment reading was the lowest since 2007 and appears to have stabilised below 5%. Jobless claims not only have fallen but are now at the lowest level they have ever been since the data started to be collected in 1980.
More evidence of the healthy state of the US labour market is found on the latest Beige Book, in which the Federal Reserve captures anecdotal evidence on the state of the economy. The signs are consistent with continued employment expansion, and either rising wages or difficulty filling positions in a majority of the districts.
Despite the most recent reading being slightly disappointing (2.5% increase YoY) the trend in wage growth also continues to be positive.
Together with wage inflation, consumer prices are starting to pick up, supported by the fact that the effect of cheaper oil has been fading. Retail sales have also improved quite significantly in the second part of 2016 with the latest reading indicating a 7.4% increase YoY.
…even hotter than labour data suggests?
On many measures therefore, the economy may seem superficially to already be running at high pressure. Moreover, as Tristan Hanson discussed in August and Richard Woolnough mentioned in the comments to a Bond Vigilantes post in January, there are signs that the lower participation rate should not be interpreted as indicating a high degree of slack in the economy.
This view has been supported by a recent study from the San Francisco Fed, which found that the combination of a growing retired population and of a lower labour participation (especially amongst younger people) experienced by the US labour force, “reduced the trend rate of job growth needed to maintain full employment and is expected to continue doing so in the future.”
The bond sell-off: not just about Trump
In this context, it is too simplistic to think that the market has “jumped the gun” and read too much into Donald Trump’s election rhetoric. Yield increases are consistent with the improving data noted above, but more importantly simply reflect the fact that bonds in the middle of the year looked ripe for a sell-off.
By the end of June, yields were for the most part at historic lows after episodic declines in the first quarter and post-Brexit. The moves we have seen since simply represent an unwinding of this behavior and have only served to take us back to where we started the year.
The market has been prompt to attribute the reasons of such moves to the new republican administration plan, potential fiscal stimulus and infrastructure program but the simple interpretation of data available would have suggested a similar shift. If we add to this the growing sense that there is a risk to bonds from changing policy making ideology around the world, then it seems that Trump-centric explanations for price action might be missing something.
It may be that we have seen the worst of yield increases in the near term but this may be less about whether investors will come to re-evaluate their feeling on Trump, and more other dynamics.
Whether the US economy continues to display signs of strength and how the Fed responds to this will be critical, but so will changes to investors’ perceptions of the riskiness of the asset class. Either of these forces can be subject to some reversal but ultimately their impact will be more sustained than knee-jerk reactions to Trump’s policy rhetoric.