The "Trump trade" hits bonds

Ten-year US Treasury yields rose to 4.47 per cent as bond desks bet on the 'Trump trade'. With the political outlook shifting, investors are pricing in a fiscal agenda built on universal tariffs and on longer corporate tax cuts paid for with more borrowing.

From debate night to Monday

The move has built over three sessions. President Biden's faltering debate performance on 27 June lifted the odds of a Republican victory in November, and of a Republican-controlled Congress alongside it, and long-dated yields rose on the Friday even as inflation data came in soft. They rose again, and faster, on Monday. The two-year yield moved much less, so the gap between short and long maturities has narrowed sharply and the curve's long inversion has eased, a pattern bond traders call a bear steepening.

The pattern matters because it identifies the source. A move driven by expectations for Fed policy would push short yields up at least as much as long ones. A move concentrated at the long end is about inflation risk and the supply of bonds over the next decade, which is where fiscal policy and trade policy do their damage.

Tariffs and more supply

Investors expect a broad tariff regime to act as an immediate supply shock, lifting headline inflation and limiting how far the Federal Reserve can cut rates. The Treasury would have to sell a steady stream of long-dated debt to pay for trillions of dollars in extended tax cuts. Private buyers will want a noticeably higher yield to absorb it.

The supply point is sharper than it looks. The Treasury has leaned heavily on short-dated bills to finance recent deficits, which has spared the long end some pressure, but that approach has limits, since too much short-term funding exposes the budget to every change in policy rates. A larger structural deficit would eventually have to be financed with more notes and bonds. At the same time the Fed is still shrinking its holdings, although it cut the monthly cap on Treasury run-off from $60 billion to $25 billion in June, and large foreign buyers such as China have been reducing their Treasury portfolios for years. The marginal buyer is increasingly a price-sensitive private investor.

Where the risk premium shows up

The extra yield investors demand for holding long bonds rather than rolling short ones, the term premium, was close to zero or negative for much of the past decade, when the Fed was buying bonds and inflation was quiet. It has recovered since last year, and the latest move adds to it. Each increase feeds directly into thirty-year mortgage rates and into the yields on long-dated corporate debt, which price off Treasuries. Homebuilders, commercial property owners and companies planning long-term borrowing feel it first.

Currencies are carrying part of the trade as well. The dollar has firmed on the prospect of tariffs and a Fed that cuts more slowly, while the Mexican peso and the Chinese yuan, the currencies most exposed to American trade policy, have weakened. Banks gain from a steeper curve, since they fund themselves short and lend long, which is why their shares have tended to rally on days when the political odds move towards Trump.

Lessons from London and 2019

Markets have punished unfunded tax cuts before. In September 2022 Britain's government announced large tax cuts with no plan to pay for them, and gilt yields surged so fast that the Bank of England had to intervene to protect pension funds; the prime minister was gone within weeks. America's position is far stronger, since it issues the world's reserve currency and the deepest bond market, but the episode showed that fiscal credibility can be priced suddenly rather than gradually.

The trade war of 2018 and 2019 offers a counter-lesson. Tariffs on Chinese goods then did raise some prices, but they also hurt business investment and confidence, and the Fed ended up cutting rates three times in 2019 as growth slowed. Long yields fell sharply that year. A tariff shock, in other words, can be as much a growth shock as an inflation shock, and the bond market's first reaction is not always its last.

The case against the trade

The strongest objection is that the election is four months away and much can change, including the Democratic ticket. Campaign promises also tend to be diluted once they meet Congress: extending the 2017 tax cuts is likely under either party in some form, and sweeping tariffs could face legal and political resistance. On this view the market is pricing a policy mix that may never arrive in full, and the move could reverse quickly if polls shift. There is also a cyclical argument. Inflation is cooling, and a Fed that begins cutting in the autumn would pull the whole curve lower, political premium or not.

Those arguments limit how far the trade can run on politics alone. They do not remove the underlying fiscal problem, which exists whoever wins, since neither candidate has proposed a credible plan to narrow a deficit running above 6 per cent of GDP. The Biden administration's proposals to raise taxes on companies and high earners would need a Democratic Congress to pass, and the same betting markets that moved on the debate now rate that as the less likely outcome.

Signals to follow

The June payroll report arrives on Friday and the June consumer price index the following week, and soft numbers could offset some of the political premium. Powell testifies to Congress next week, and the Treasury's quarterly refunding announcement at the end of July will set the size of coupon auctions for the months ahead. Polls in the swing states, and the spread between two- and ten-year yields, are the cleanest gauges of how much politics is in the price.

Bond investors are treating tariffs and unfunded tax cuts as a formula for higher inflation and heavier supply. If the polls keep moving Trump's way, ten-year yields will probably climb further, and the Fed will have less room to ease. Borrowers who price off the long end, above all homebuyers, should expect little relief from the Fed's first cuts, because the long end is now being set by Washington's budget as much as by the central bank.