Trump hits reset on global monetary policy settings

The risk that the market is snapping back from its long-term global trend is very real, and could become savage.

Yields around the world have been dragged up by the big shift in expectations. Picture: AP Photo/Richard Drew.

Could Donald Trump’s election, just as the world’s key central banks are signalling the near-exhaustion of unconventional monetary policies, create the moment that ends the 35-year bull market in bonds? The initial indications are that it might.

The stock market euphoria, after a momentary gulp, that greeted Trump’s success was based on his planned big tax cuts for US companies and rich individuals along with a the massive infrastructure investment program that, if implemented, will boost US growth — and inflation.

That unexpected and quite dramatic outlook for a big boost to growth and inflation — and US debt — triggered a meltdown in global bond markets last week, with losses estimated at more than $US1.2 trillion as prices fell and yields rose, a trend that appears to be continuing.

Trump’s program strengthens the case for the US Federal Reserve Board to shift its expectations of the rate and extent to which it should lift official US interest rates over the next few years, a process of “normalisation” of monetary policy that could resume as early as next month.

An accelerated US economic recovery and a structural shift in expectations of future US rates is reverberating throughout the highly connected global financial markets and comes against the backdrop of implicit admissions by the European Central Bank and Bank of Japan that the usefulness of their negative rate and bond-buying programs may now be outweighed by their negative side-effects on financial sector profitability and stability.

The Bank for International Settlements’ general manager, Jaime Caruana, gave a speech in London overnight in which he referred to the “previously unthinkable” portion of major government bond markets trading at negative yields.

More than $US7.5 trillion of sovereign bonds within the major economies, and even some corporate debt, have been trading at negative rates.

The willingness of investors to pay governments, and even companies, to look after their savings was a measure of how fearful they have become within what was uncharted financial markets territory and how depressed they have been about the long term outlook for the global economy.

Caruana said investors risked putting too much weight on slow growth, or even secular stagnation, in their understanding of the ultra-low yields in the market and that there was a corresponding risk that they put too little weight on unconventional monetary policy and market dynamics.

“One implication is that asset managers should reflect upon snapback risk, and risk managers should make sure that they do,” he said.

While it is too early to declare the abrupt change in market circumstances decisive — much will depend on what Trump actually does once he takes office as opposed to what he said he would do during the campaign — the evidence of the past week would suggest that the “snapback risk” is very real and, given the starting points for bonds, particularly long-dated bonds within flat yield curves, potentially quite savage.

The bull market in bonds was built on relatively modest but consistent rates of real growth in the major economies from the 1980s as globalisation accelerated and the success of the key central banks in controlling inflation, which saw nominal bond yields generally trend steadily lower.

In the post-crisis period, central banks collapsed yields and forced bond investors to take on increasing term risk, squashing the significant premium usually demanded for the uncertainties and risk associated with longer-dated debt.

The “snapback” Caruana referred to could involve either short-term rates or the longer dated securities.

Over the past week, the entire US yield curve has moved up sharply, with spill-over effects into other bond markets.

The US 10-year yield hit a record low of 1.366 in early July. It’s now almost a full percentage point higher as the market starts to factor in the inflationary implications, and risks, of the Trump ascendancy. The 30-year bonds traded above three per cent for the first time since the start of the year.

Term premiums are back on investors’ agenda as they factor in both the implications for inflation of Trump’s agenda along with the impact on the already high levels of US government deficits and debt and the risks associated with his “America First” protectionism and isolationist policies.

The conviction that US rates may be higher than previously factored into investors’ thinking will have ripple effects, particularly if the Fed reinforces it with a December rate rise and a more aggressive outlook for future rate hikes.

Yields around the world have been dragged up by the big shift in expectations — in some emerging markets they have soared — while the US dollar has also strengthened against most major currencies.

Emerging market stocks have been sold off. There are concerns that a stronger dollar and higher US rates and increased global flows of capital towards the US will cause stress within emerging market economies that have over-loaded on cheap US dollar-denominated debt in the post-crisis period.

While the “snapback” in bond markets could, if sustained, create some unpleasant moments and some heavy losses for investors conditioned by the major central banks since 2008 to believe rates would remain ultra-low for an ultra-long period (and that the central banks would bail them out the moment there was a suggestion of stress), in the long run it could be a very positive development.

The era of ever-more unconventional monetary policies has seen, not just term premiums but risk premiums more broadly, disappear from markets as investors were forced to take on increasing risks for decreasing returns.

In the long run that had to be unsustainable and the longer the settings persisted the larger the unintended consequences — financial and property market bubbles, widening inequality and the hollowing out of financial institutions among them — have become.

It could be argued that the Fed and its peers helped get Trump elected and provided the foundations for Brexit and the general backlash against the “elites” that is now echoing around the developed world.

A shift from monetary policies that have had reducing impacts on growth to fiscal policies might create longer term challenges for economies that are already over-leveraged but may help restore more conventional risk-reward frameworks to settings that have been distorted by the proliferation of negative-yielding sovereign debt within the developed economies.

If the sudden change in investors’ expectations in the immediate aftermath of the US election is sustained, then the heightened expectations for inflation and the risks of trade frictions and worse inherent in the Trump platform dictate a return to something closer to a more conventional yield curve.

That’s a change in global settings that, more than eight years after the financial, crisis, is long overdue.