With Trump's border tax adjustment looking increasingly likely, the stock market - as JPM has warned in recent days - is starting to fade the relentless Trumponomic, hope-driven rally since election day instead focusing on the details inside the president-elect's proposed plans. And, as explained earlier in the week, if the border tax proposal is implemented, economists at Deutsche Bank estimate the tax could send inflation far above the Federal Reserve's 2% target and drive a 15% surge in the dollar.
While this would be bad for stocks, as a 5% increase in the dollar translates into about a 3% negative earnings revision for the S&P 500 all else equal, a surge in inflation would also wreak havoc on bond prices, and send interest rates surging, at least initially, before they subsquently plunge as a result of a rapidly tightening, deep "behind the curve" Fed unleashes a curve inversion and recessionary stagflation becomes the bogeyman du jour.
In a separate report by Deutsche, the bank looks at future prospects for rates and concludes that "tightening monetary policy, higher breakevens, and declining central bank purchases relative to net supply should all contribute to significant bearish steepening during 2017."
In its analysis of future bond rates, Deutsche Bank says that the biggest risk is that when looking at the menu of "threats" presented by the Trump stimulus, "there is a significant risk that if the Fed decides to aggressively lean against higher inflation expectations, the entire “regime shift” might stall. That is, higher wages and inflation expectations are a prerequisite to the substitution of capital for labor, which is in itself necessary for more rapid productivity growth and hence higher potential growth and sustainably higher levels of r*."
And then the focus shifts so that whatever degree of accommodation is warranted, there will be the push to rebalance away from rising short rates to shrinking the Fed’s balance sheet, in other words, the Fed begins real normalization.
In DB's model, the net effect of ending reinvestment of SOMA portfolio run-off, some asset sales, and an ECB taper is almost 200 bps. This would allows 10s to move well over 4 percent in 2018. That although roll offs are significant - maybe $50 billion/month – in order to get the balance sheet down from more than $4 trillion to say $1 trillion before the 4-year presidential term is over would still require asset sales of approximately $50 billion.
Assuming Deutsche Bank is correct, the result would be the scariest forecast bond bulls have seen in years: a 10-Year TSY whose yield fades all gains attained during the past decade, in the span of just two short years, hitting 4.5% in early 2019. The adverse implications from such a fast, steep move on all asset classes, not just bonds, would be devastating.
Will this forecast come true? Readers can make their own determinations upon reading DB's assumptions:
Formally, DB's model of 10s has three explanatory variables. The main driver is the ratio global QE purchases to net supply in nominal terms with a nine-month lead, i.e., the market is forward looking. Global QE and supply figures are from the US, Europe and Japan. The other two variables in the model are Fed funds and the 2s/funds spread. The model is estimated between October 2006 and September 2016.
These assumptions are summarized in the following three scenarios:
- Base case: Trump’s fiscal stimulus, amounting to about $530 billion per year for ten years.
- Base case + ECB taper + Fed portfolio rolloff. In this case, 10s are about +70bp higher in yields than in the base case.
- Base case + ECB taper + Fed portfolio rolloff + Fed asset sales. 10s are about +100bp higher in yields than in base case.
The assumptions in the scenarios are:
- President-elect Trump’s stimulus package, scored by the Committee for a Responsible Federal Budget adds $5.3 trillion to the deficit over the next decade. This averages to $530 billion per year, starting in July 2017, around the time the plan is expected to be passed by Congress.
- The ECB tapers QE purchases by ½ in 2018, and stops all purchases in 2019.
- Fed balance sheet reductions: The Fed stops reinvestments of maturing Treasuries and MBS pre-payments starting Q4 2017. Asset sales at $250 billion in 2018 and $500 billion in 2019.
- The Fed funds target range rises to 2.50%-2.75% by year end 2019, with the 2s/funds spread at 60bp.
Needless to say, DB is convinced that there is a lot of pain coming for the bond market. To wit:
"Our strongest market view, therefore, is that investors should be short duration. Rates are going higher. The curve should end up steeper but this Fed's initial reaction as per this week can confuse curve dynamics. Real rates should not rise more than breakevens. In the short run dollar strength should persist."
We are far less confident, especially if indeed the border tax is implemented, sending the dollar soaring, US exports, and GDP crashing, and corporate profits plunge. In short: if Trump unleashes a recession by implementing a policy which is meant to eliminate the US trade deficit.
In such a case, forget steepeners: buy every flattener you can get your hands on, and then use leverage, because before you know it the 2s30s will be back in the double digits, then single, and then, not too long from now, negative.
Whether that is the catalyst that will kick off QE4 or whatever the current number is, we don't know, but by that point China will be spitting up blood as a result of a historic collapse in the Yuan, hundreds of billions in monthly outflows and a paralyzed, and crushed financial system. Ironically, in light of the devastation that may soon befall China should Trump's policies pan out, the US - recession or not - may still be the "cleanest dirty shirt" in a world where things are about to get very messy.