(Bloomberg) — It took much of the first half of the year for Treasury bond investors to fall in line with a Federal Reserve signaling higher and longer interest rates. Now, as they consider the timing of a second-half twist, they also must contend with the potential wild card risks of a hotly contested presidential race.
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The U.S. bond market moved closer to breakeven, thanks to two straight months of gains that left the benchmark Treasury index down just 0.15% for 2024, compared to July. As traders focus on each data point, extending the current trend – Treasuries have failed to achieve more than two consecutive months of gains since 2021 – will require lasting evidence of a slowdown in economy and lower inflation which would increase the chances of an economic slowdown. rate cut from September.
Investors who expected six rate cuts in January are now more comfortable with a central bank willing to hold its monetary policy as long as necessary. Still, traders are pricing in at least a quarter-point cut by year-end and see a strong likelihood of two. Whenever it happens, it will be a momentous event, likely to put the Treasury market on a path to normalcy after a record two years in which yields on short-term debt outpaced their longer-term counterparts.
Added to the mix is the US election cycle, with the first presidential debate between President Joe Biden and his predecessor Donald Trump scheduled for Thursday. The additional risks and unknowns around the election campaign could serve as an additional catalyst to shake up the curve and reward investors who bet on a return to a normal rate structure, a bet that has not paid off so far while the Fed remained unchanged. .
“Certainly, we may see a bit of volatility in the markets as the election approaches,” said Gargi Chaudhuri, head of iShares investment strategy for the Americas at BlackRock Inc.
Right now, U.S. 10-year yields are trading around 4.25%, about half a percentage point lower than those on two-year Treasuries.
Tellingly, neither Biden nor Trump appears willing to end high deficit spending. So, under either administration, spiraling U.S. debt could lead investors to demand a higher premium to hold longer-term Treasuries. Attention will also focus Thursday and beyond on whether Trump signals a desire to test central bank independence — or the extent to which either candidate steps foot in his mouth.
“There is a lot of concern that regardless of the outcome of the presidential election, the issue of increasing deficits and increasing debt as a percentage of GDP is not going to go away,” Chaudhuri said.
In a year full of elections around the world, markets have already swooned following Mexico’s results in June, which could open the door to sweeping constitutional changes. France is heading towards elections soon and this hasty decision by President Emmanuel Macron has triggered a public debt crisis.
“Think about the French elections or the French announcement,” said John Madziyire, portfolio manager at Vanguard. “No one knows what the outcome will be, all you know is that you need to start reducing your positions in French bonds given this uncertainty.”
It remains to be seen whether Treasuries will receive similar treatment in the run-up to the election – although the US remains buoyed by its global safe-haven status for now. What is clear is that investors are already largely wary of both candidates’ propensity to worsen the nearly $2 trillion U.S. budget deficit and growing U.S. debt – whether through increased spending, lower taxes, or some combination. These topics will likely be discussed on Thursday.
Outstanding Treasury debt currently stands at $27 trillion, more than six times the size of the U.S. government debt market in mid-2007. The nonpartisan Congressional Budget Office projects that chronic deficits will push the U.S. debt to about $50 trillion by the end of 2034.
As the Treasury sells more long-term bonds to finance the deficit, this supply will put upward pressure on yields. But beyond that, and more worrying for some investors, is the idea that current long-term returns do not adequately reflect increased fiscal and related risks.
A Fed model of the so-called term premium for 10-year Treasury notes – an approximation of the extra return investors demand for the risk of taking on long-term debt rather than rolling over securities at short term – is currently in negative territory. . At around -0.27%, it is well below the high of 0.46% recorded last October, when fiscal concerns were acute.
The risk is that the premium turns positive and widens as the election puts the focus back on deficits and debt – something TD Securities cited in a note this week. And if one party takes control of the White House and Congress, the risk will be amplified, market observers say, because it would increase the chances that deficit-increasing legislation will be passed.
“It doesn’t really matter, Democrats or Republicans, but if one party takes control, which means deficits get worse, then you should comfortably sell short the long term,” Ed Al- said Hussainy, rates strategist at Columbia Threadneedle Investment. He sees “perhaps still more than 50 basis points of upside in terms of term premium.”
For many investors, economic data and Fed policy remain top of mind even as the election approaches. But even then, tax factors can play a role.
One area where there appears to be a difference between the candidates is the independence of the Fed, a topic that has emerged as a campaign issue amid reports that some informal Trump advisers have floated ideas on possible changes that would give it more power over the central bank.
Forty-four percent of respondents in a recent Bloomberg Markets Live Pulse poll said they expected Trump to seek to politicize the central bank or limit its power if he returns to the House White.
The reality is that a newly elected Trump would likely be limited in his ability to make big changes at the Fed beyond appointments. But for some investors, even the idea of a loss of central bank independence means risk premia should be higher.
“After so many seemingly unthinkable things that have happened in recent years, investors have learned that you should never say never,” said Marion Le Morhedec, global head of fixed income at AXA Investment Managers SA.
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