If Donald Trump wins the US election next week, inflation would rise, the budget deficit would increase and the Federal Reserve would probably cut rates at a slower pace than currently expected, fund managers predict.
Nicolas Trindade, who manages the AXA Global Short Duration Bond fund, said a Republican victory would be “very disruptive” for bond markets and would drive treasury yields higher, causing a rapid steeping of the yield curve that “could potentially be really painful for a lot of fixed-income investors”.
Both presidential candidates have made spending pledges that would increase the US government’s deficit, although Trump – who once called himself the ‘king of debt’ – is expected to ramp up borrowing more than Kamala Harris.
FE fundinfo Alpha Manager Trindade believes Trump would extend a series of tax cuts that are due to expire, creating a tailwind for growth but adding inflationary pressure. Tariffs on imports from China, Europe and elsewhere, as well as a clamp down on immigration, would also cause prices to rise in the US.
The scale of Trump’s potential victory would be a critical factor, according to Raphael Olszyna-Marzys, international economist at J. Safra Sarasin Sustainable Asset Management. “A Republican sweep is the worst outcome for bonds,” he said.
“President Trump’s policies with lower taxes, more deregulation, tighter immigration policies and the likely implementation of broad-based tariffs will lead to higher inflation expectations, a significant increase in budget deficits, but also increased policy uncertainty. Markets would likely price a shallower Fed rate cut cycle and a higher term premium to account for the additional uncertainty.”
If Congress is divided, however, Trump would have less leeway to implement his policies and the market reaction would be more muted, Olszyna-Marzys explained.
Global government bonds have been selling off rapidly during the past six weeks – not just in anticipation of a Trump presidency but also in reaction to strong US economic data, said Ashok Bhatia, co-chief investment officer for fixed income at Neuberger Berman.
“Bond yields have surged because, after a weak August, September saw a string of US releases deliver upside surprises, including a blockbuster payrolls report and warmer-than-expected retail sales and inflation,” he explained.
Bhatia thinks “this could be just the beginning of a surprisingly sustained move higher in yields”.
He expects the Fed to cut rates by 0.25% next week and in December, but it could then potentially take a pause during the first quarter of next year. “It is hard to imagine the Fed next year mechanically delivering rate cut after rate cut in the face of 2.5% GDP growth and increasingly stubborn inflation.”
A Fed pause could spark fears of a return to rate hikes and have an outsized impact on the yield curve, the co-CIO said.
“The recent sell-off has taken yields back only to the levels of late July, just before a very weak US payrolls report and the unwind of the yen carry trade created a big bid for bonds. It would not be surprising to see the US five-year yield add another 50 basis points from here, taking us back to the mid-2024 highs.”
Arif Husain, head of fixed income at T. Rowe Price, also expects yields to continue rising. “The 10-year treasury yield will test the 5% threshold in the next six months”, he predicted, up from 4.3% on 29 October.
“Ongoing issuance by the US Treasury to fund the government’s deficit spending is flooding the market with new supply,” Husain explained. “The Federal Reserve’s quantitative tightening has taken a large, reliable buyer of treasuries out of the market, further skewing the balance of supply and demand in favour of higher yields.”
Managers are preparing for this eventuality by shortening duration. David Roberts, co- manager of the Nedgroup Investments Global Strategic Bond fund, has started selling down the US, shortening interest rate exposure. The fund is underweight US bonds and “closer to the election, I may go further – possibly to zero or, whisper it… short”.
In client portfolios where Neuberger Berman has the most freedom, Bhatia and his colleagues have reduced duration to around 3.5 years; just over half the duration of the major investment grade benchmarks.
“Moreover, with US investment grade corporate bond spreads as tight as they have been for almost 20 years, we are also cautious on corporate credit, where a move back to 4.5% in the five-year yield could cause a disorderly exit,” he said.
“Investors who need exposure would be better off looking at structured products such as investment grade collateralised debt obligations or mortgage-backed securities, where spreads still offer a thicker cushion.”
Trindade also expects short-dated bonds to weather the oncoming storm better. He is keeping duration at two years in his AXA Global Short Duration Bond fund, which has a 5% yield, meaning that it could withstand a rise in yields of 250 basis points before posting a negative total return.
“If we see treasury yields rising further, then we'll have plenty of space in the strategy to add duration at better levels,” he continued. About 20% of the portfolio matures each year and in a rising rate environment, the proceeds can be reinvested into bonds with higher yields.