Politics won’t trump data for the Fed

The last few weeks have seen former President Donald Trump establish a lead over current President Joe Biden across polls in the run-up to November’s US election. Even though it is early days and a lot can change before November (including the Democrat candidate), it is worth considering what a second Trump term might mean for the world economy and for fixed income markets.

The leading narrative thus far has been that a Trump presidency would mean more growth, more inflation, higher yields, and a steeper US Treasury (UST) curve. Proposed tariffs would add price pressure at a time when the issue of inflation has perhaps not been totally dealt with. Tax cuts could also be inflationary and have the additional impact of keeping the budget deficit at elevated levels – resulting in higher expected supply and a negative technical for USTs.

While that assessment has its merits, there are many other variables to consider. To start with, the composition of Congress will matter greatly. If the Democrats were to control just one of the House or the Senate, then the scope for Trump to change policy more dramatically would be reduced. The most recent debt ceiling agreement, reached two years ago after weeks of severe uncertainty, resulted in a suspension of the debt limit until January 2025. This will need to be renegotiated. In any election, not all the winning candidate’s initiatives presented before the vote see the light of day. Some can be enacted by executive order, but not the majority.

Tariffs were perhaps the defining economic policy of the Trump administration, and they could well be again with the former president proposing a 10% tariff on all imports and a 60% levy on Chinese goods. There is, however, a question mark over how markets would react to the increase or introduction of new tariffs. During Trump’s presidency, escalations in the trade war with China were typically met with a rally in USTs; rather than the inflationary impact of tariffs, markets were focused on geopolitical tension being bad for global growth and USTs are the global risk-off instrument. This time around Trump could arguably face a less friendly bond market if investors remain concerned about inflation. However, the market is only growing more comfortable with inflation and so, by the time any commerce conflict with China begins, growth and jobs rather than inflation may be at the forefront of people’s minds – any trade war flare-ups could once again be met with a risk-off UST rally.

This brings us to the crucial point; whatever the race for the White House is driven by – trade, immigration, age – the Federal Reserve (Fed) remains data-driven. Its dual mandate areas of inflation and employment have dominated markets in the aftermath of the Covid-19 pandemic and will continue to do so. That much was clear last week in the reaction to lower-than-expected US inflation data, which brought a double-digit basis point rally across the UST curve and a percentage point rally in high yield credit. Without a doubt fiscal policy is one of the inputs the Fed takes into account when setting policy, but this is to the extent that it affects the macro outlook.

With the last few inflation prints showing encouraging signs and the jobs market also cooling, futures are now pricing in close to three 25bp rate cuts from the Fed by year-end (up from just one in April) and the 10-year UST yield is 50bp lower than its April peak – all while Trump has been trending higher in the polls. There will be six more inflation and jobs prints before the next president is inaugurated and these releases, along with the Fed’s subsequent actions and rhetoric, will be the main influence on fixed income markets.

Over the last couple of years the yield curve has been one of the main sources of volatility for fixed income investors. A potential Trump presidency may cause some additional volatility, but while there is a scenario in which the curve settles at higher yield levels, the exact impact is uncertain.

Inflation and jobs will remain the main show in town for the time being and these are moving in the direction the Fed is predicting, which should translate into rate cuts. We think USTs will continue to trade in a range for now, and at these levels offer good insurance for risk-off events. However, given we expect carry to be the main driver of returns in the coming months, we think credit is likely to continue to outperform government bonds.