The ingeneous man Don Trump of la Mancha
Just like Cervante’s classic “The ingeneous man Don Quixote of la Mancha”, Don Trump will provide many enjoyable hours of entertainment as he tilts at the establishment windmill that is ‘the US Government’. Just like Don Quixote, Don Trump will find his windmill impossible to beat…an impossible dream.
But whereas Don Quixote led a self-important life with zero international recognition, Don Trump was already a household name before adding US President to his CV. His unorthodox campaign ingeneously rejected the interests of the powerful liberal-socialist Fourth Estate, making him the villain of the media, blamed for everything that is bad. Pollution, shootings, racial discontent, the breakdown in Chinese diplomatic relations and even price inflation…
Inflation? Don Trump definitely has an inflated ego and inflated promises, but how can he possibly be tagged as a cause of price inflation? The logic goes like this : (i) bond yields rose after Trump got elected, (ii) higher bond yields reflect higher inflation expectations, so therefore (iii) Trump causes inflation.The weakness in this argument is item (ii) in the logic chain which holds that higher bond yields only reflect higher inflation expectations. This is rubbish. Higher bond yields can reflect a number of things such as an increase in the real interest rate reflecting higher productivity of capital, a change in risk aversion and market risk premia, short-term liquidity effects associated with portfolio rebalancing as well as other stuff. Let me elaborate…
1. Productivity of capital. Investors borrow to invest provided their rate of return on capital exceeds the rate of interest. An event which makes investing more profitable therefore permits higher rates of interest. Trump is business friendly, has promised to cut regulation etc so it is easy to make a case for increased profits under his administration. The stock market definitely thinks so. The spike in longer term bond yields probably reflects this in part.
2. Risk aversion and risk premia. Investors hate uncertainty and each chapter of Don Trump’s classic journey will be as astonishing as the US primaries and the election itself. The market is populated by many who simply don’t want to take a risk unless compensated for it. Investors seize upon events to reprice risk temporarily, and then wait and see what happens before venturing out of the relative safety of their cave of cash. I think there is a lot of this behaviour driving the increase in bond yields – Trump triggered a temporary spike in risk aversion. The key word here is ‘temporary’, so that we can expect the increase in yields to reverse.
3. Liquidity effects and portfolio rebalancing. This is a nice way of saying leveraged investors panicked as their stop loss levels were hit, in turn causing bond prices to fall triggering more stops etc. This is difficult to prove but there is a good deal of circumstantial evidence. The most relevant fact available is the rapid pace with which long term interest rates rose, with the US 30yr yield spiking 0.50% higher in less than 5 days. Now, the big USTreasury investors (such as the Asian and Middle Eastern Central Banks and Sovereign Wealth Funds) DO NOT make decisions to re-allocate their holdings this quickly. It may take months or even years for these investors to get approval to alter their benchmarks, and then many years on top of this to actually change their portfolios. China, Japan, Saudi Arabia – in fact, every single Sovereign investor – DID NOT react to Don Trump’s election win.
So who is able to be so nimble? Hedge Funds, prop traders and leveraged accounts have this character. The interesting aspect of these investors is that they account for a disproportionate quantity of trading relative to their physical holdings. Once the dust settles from having been stopped out, the big US Treasury investors will move in to clean up the mess, re-stocking their portfolios with (now cheaper) Treasury securities, in turn leading yields down again.
Where is inflation in all this? The above provides 3 non-inflation related reasons for a temporary rise in bond yields. Inflation is a subtle concept, and far beyond Don Trump’s capabilities. First, inflation is the rate of change of prices and applies to all prices at once. For inflation to rise, the rise in the general price level must accelerate permanently. Second, an acceleration in the general price level can only happen provided monetary policy accommodates this higher pace. Don Trump DOES NOT have the power to expand the money supply since this rests with the Federal Reserve. Third, and more practically, Ben Bernanke and Janet Yellen have been trying to kickstart inflation for years without success, and they control the monetary policy tools. These tools have proved useless for the reason that the transactions demand for money is in structural decline (as I have argued in earlier posts).
Trump can be tagged with many things, depending on your politics, but not as an inflation generator. This means that the increase in bond yields is capped and probably temporary. Bonds suddenly look very cheap.