The election of Donald Trump as US President shocked the world and shocked the world’s markets. Yet that early reaction quickly morphed into euphoria, as stock indices in America experienced huge inflows and hit record highs.
For investors left high and dry as trillions of dollars drained from safer fixed income bonds into riskier equities, the question is whether anything can stop the Trump train’s progress, or whether his election and inauguration this week marks the end of a 30-year bull run in government bonds.
The flow of $1.7 trillion (£1.4 trillion) from bonds to equities over the course of three weeks was prompted by markets piecing together what they learned of the President elect’s policies on the campaign trail. Yields, which move inversely to prices, on the benchmark US 10-year Treasury rose from below 1.8 per cent before the election to December highs of over 2.6 per cent.
Read more: What's causing the bond sell-off?
The massive deficit implied by tax cuts allied to a trillion-dollar increase in infrastructure spending led to consensus expectations of a de facto fiscal stimulus.
This in turn is expected to raise inflationary pressure – with the inelegant moniker Trumpflation – making bonds less attractive as future income payments, the so-called coupon, are worth less in real terms as the currency depreciates.
What makes the picture even bleaker for bonds across the globe is the Federal Reserve's tightening of monetary policy in response to the threat of higher inflation, as it tries to reduce the flow of cheap money into the economy.
“Fundamentally bonds are poor value,” says Christopher Bailey, European strategist at asset manager Raymond James – suggesting some form of further sell-off is possible. The chance of yields falling back down again is “low”, he says.
However, the consensus rush out of bonds may have been overdone, with Trump’s chaotic press conference last week adding to feelings of buyer’s remorse for the “reflation” trade, which is based on the expectation of growth under the new administration.
There were already some stridently anti-consensus voices out there, saying bond prices would continue to rise. HSBC’s global head of fixed income research, Steven Major, sees US 10-year yields plunging to 1.35 per cent by the end of 2017 from current levels of around 2.4 per cent – but even less contrarian investors have moderated slightly in recent weeks.
Since 15 December the JP Morgan Global Aggregate Bond Index has risen by more than two per cent, as investors await detail on fiscal stimulus. John Bilton, global head of multi-asset strategy at JP Morgan Asset Management, said: “The idea that we’re in the middle of a massive rotation [of money from bonds to equities] is not something that will necessarily follow through.”
While the top end of his range on the US 10-year yield sees a rise to 2.75 per cent in 2017, the level of potential economic growth is “just not enough to justify a massive surge in bond yields,” he says. So yields may not rise dramatically, and could even fall slightly.
Joe Brusuelas, New York-based chief economist for RSM, says: “Investors should be prepared for some volatility around the reflation trade.” Trump’s team has some “very ambitious goals” on the economy, but there is at least “broad bipartisan support for modernising American infrastructure,” he says.
The risks are by no means limited to the US. And Trump isn’t the only political risk around: despite the relative sizes of Europe’s individual economies, contagion can carry far.
This was shown spectacularly in 2016 by the Brexit vote, which drove the US 10-year yield to its record lowest level below 1.37 per cent two weeks later. Adverse results in elections this year in Europe – particularly in France – still have the potential to endanger the euro.
Any big threat to the European project could send investors running for safe haven cover, even with high US inflation and interest rates.
The continued Brexit rollercoaster could also lead to a white-knuckle year for UK government gilts. “We are still concerned about the gilt market going into 2017,” says Bilton.
Yet for all the risks, the consensus is still firmly in favour of the Trump reflation narrative to hold and for a rise in yields over the course of 2017.
“We’ve entered the end stages of the bull market but it will be some time before the bull market normalises,” says Brusuelas.
It may well turn out to be the beginning of the end of the bond bull run, but expect a bumpy ride in an era of radical uncertainty – for fixed income investors and for the wider world.