Amy Xie Patrick: What’s next for bonds under a Trump administration

Shorting bonds may no longer be the best trade, argues Pendal’s head of income strategies AMY XIE PATRICK

• Bonds carry plenty of risk premium for the uncertainty that lies ahead
• Hedge funds piling on short US bond bets “like no other time in recorded history”
• Find out more about the Pendal Monthly Income Plus Fund

IN the final weeks leading up to the US election, political pollsters said it would be a close call.

Bond markets, on the other hand, traded like a Trump victory was in the bag.

While the market continues to show little love for bonds in the aftermath of the “Red Sweep”, this article looks at whether the bond short remains the correct “Trump trade”.

What’s priced in?

Bonds have had a busy time. For most of the year, US bond yields have danced between large and small rate cut expectations, fuelled by recession fears and resilient data, respectively.

Despite the US Federal Reserve (the Fed) kicking off this easing cycle with a 50 basis point (bp) cut to the Fed Funds Rate in September, bond yields have failed to fall any lower.

The fear of a Trump victory and the anticipation of his economic policies have played a large part in the most recent bond sell-off.

This move has been similar to the post-election bond market reaction in 2016.

After some immediate confusion as to whether a Trump presidency would herald the end of civilisation as the world had known it, bond yields started to take off. This made sense, as tax cuts and corporate repatriation tax breaks were lifting US growth expectations across the board.

The Fed was also engaged in a hiking cycle.

Between the 2016 US election and the middle of 2018, most tax cuts and repatriation flows had already happened. In that same window, US 10-year Treasury yields climbed by nearly 1.00%.

This time around, bond yields started to move ahead of the US election.

Since the September Fed rate cut (and there has been another cut since then), US 10-year bond yields have climbed by close to 0.9%.

Source: Bloomberg

This latest rise in US bond yields has effectively erased all the market’s anticipation of how the Fed easing cycle would play out on longer-dated bond yields.

It could even be argued that this similar rise in bond yields compares as more extreme than the 2016 experience, which took place against the backdrop of a Fed tightening cycle.

While it’s impossible to say whether the full impact of Trump’s presidency is already in the price, it is certain that bonds already carry plenty of risk premium for the uncertainty that lies ahead.

The real rise in yields

The rise in US bond yields since September is not just about a fear of Trump’s policies being inflationary. Figure 3 shows that both US 10-year breakeven and real yields have marched higher.

Breakeven yields indicate the market’s view on long-term inflation expectations. Since the September FOMC meeting, 10-year breakeven yields have risen by 0.24% to 2.35%.

In other words, the market is having doubts about the Fed being able to maintain inflation at its 2% target in the long run.

Real yields, however, have risen by twice as much in the same period – from below 1.6% in September to nearly 2.1% today.

The prevailing market explanation is that the incoming Trump administration is very likely to see a worsening of the US deficit situation, leading to an increase in US government bond supply.

However, real yields can move due to both the demand for and supply of capital.

An increase in US government bond issuance represents an increase in demand for capital. But existing academic studies have found that the most significant drivers of real yields in the US are demographics and growth.

Source: Bloomberg

Ageing populations lead to higher savings rates, which increase the supply of capital – pushing down real yields.

This long-term trend is unlikely to be suddenly reversed by Trump’s policies and may, in fact, be exacerbated if the working-age population can no longer grow so easily due to more hawkish immigration policies.

GDP growth is positively linked to real yields, because when an economy grows, its need for capital tends to increase. This is why productivity growth is also tied to real yields. Higher productivity is usually a result of investment in technology and innovation – both of which require capital.

The likely effect of tax cuts and tariffs

An expansion and extension of tax cuts under the Tax Cuts and Jobs Act may indeed lift the growth rate of the US economy. But with a real yield rise of over 0.5% since September, a lot of those higher growth expectations have already been baked in.

Furthermore, tax cuts are unlikely to have the same distributional impact as the post-pandemic fiscal handouts implemented under the Biden Administration.

As illustrated in Figure 4, the poorest half of Americans still have more cash in their pockets than prior to the pandemic. The poorest one-fifth of US households have still experienced significant growth in their ex-real estate wealth since the pandemic.

In addition, trade tariffs tend to have a contractionary effect on demand and global growth.

The US economic slowdown in 2018 was evidence of this during Trump’s tariff wars with China. The deflationary effects were so strong at the time that it forced the Fed into the famous “Powell Pivot”, whereby the hiking cycle was abruptly halted (Figure 5).

Source: Bloomberg

The extent to which Trump’s policies can lift the US economic growth trajectory is uncertain. That the poorest Americans stand to benefit the most is unlikely.

Place your bets

While the US economy has remained resilient, we remind ourselves that only weeks ago recession was the main concern on the supposed breach of the “Sahm rule”. Whether the US labour market will manage to avoid further deterioration remains the main concern.

As Figure 6 highlights, once the unemployment rate starts to turn higher, recession usually follows.

Source: Bloomberg

In the meantime, global hedge funds have piled on short US bond bets like no other time in recorded history (Figure 7).

Source: Bloomberg

Asset managers’ natural positioning on Treasury futures tends to be long, as often futures will be used to ensure their portfolios’ duration do not fall short of their benchmarks. This creates room to put cash to work on higher-yielding assets like credit.

The most recent rise in the net Treasury futures position among global asset managers may be linked to their chase for credit, rather than an outright desire to extend their US government bond exposures.

Hedge fund positioning, on the other hand, tends to be driven by a direct view of how US Treasuries will fare.

In the low-rates era, hedge funds built up short positions on views that lower rates could not possibly last forever. The pandemic brought in a brief period of even lower rates and forced those hedge fund short positions to be unwound.

Since 2022, however, hedge funds have re-engaged with the short-bond trade because of concerns over inflation, the US deficit situation, and likely a multitude of other factors such as momentum.

The most recent driver of short positioning among global hedge funds seems to be the “Trump trade”. With hedge funds’ short bets on US Treasuries at an all-time high and yields having already risen significantly, the risk is that even hawkish Trump policies fail to push this trade on further.

Market positioning is never the primary driver behind our portfolio positioning decisions. However, it does inform our assessment of the risk-reward dynamic affecting any active decision we make.

If the details of Trump’s economic policies surprise to be more benign or if hawkish policies lead to disappointing market reactions, one expects profit-taking or capitulation to occur among the hedge fund community.

In other words, market positioning points to risk-reward that favours bonds. At the very least, shorting bonds may no longer be the best Trump trade.