Interest Rate Analysis: Post-Election Update
November 18, 2016
By Serafino Tobia
It’s been quite a week and a half in the bond and mortgage securities markets. Not only did the media, pollsters and market participants misread who would win the US presidential election, the market reaction to Trump winning also defied most all pre-election expectations. The market reaction in the bond markets has been swift, the 10-year Treasury benchmark is higher by some 40+ basis points (2.28% as of 11/18 vs 1.85% on election day 11/8). This reset in expectations reflects the anticipation of a new fiscal stimulus and its impact on deficit spending, inflation, and the US economy in general. The reset is also an acknowledgment that the Fed will almost certainly move to raise the Fed Funds rate in December. Certainly, some reset is warranted, however, we should be cautious to think that we will see further increases in interest rates given the possibility that the Trump administration may get side-tracked with its other agenda items such as trade, immigration, and the possibility of economic and global events impacting markets. Ultimately, the future trajectory of interest rates will be determined by actual policy changes and evidence of a real impact on economic activity and inflation.
Reset of Expectations
The capital markets have a way of immediately internalizing the future and reflecting it in current prices and interest rates. I’m not saying that market reaction is always right, in fact, markets do overreact (BREXIT, case in point). However, what’s clear is that this week’s reaction to a Trump presidency reflects a change in sentiment and direction. This particular reset reflects an expectation that a Trump presidency, along with a Republican majority in the House of Representatives and Senate, have a clear mandate to stimulate the US economy. Recall, Trump has a number of fiscal initiatives to spur economic activity:
- Infrastructure Spending – Trump has proposed upwards of a trillion dollars to be spent on fixing roads, bridges, and other projects as part of getting more Americans back to work. Democrats and Republicans in Congress support this spending and it’s expected to be an early initiative for the Trump administration.
- Tax Cuts – Trump has proposed tax reform to lower tax rates on both individuals and corporations and allow for repatriation of corporate profits for companies that are holding funds overseas to avoid taxes. Trump’s tax cut proposals are dramatic, but they aren’t too far off from the Republican House’s “Blue Print” tax proposal released this past June. Again, with Republicans controlling the House and Senate, the markets are anticipating tax reform to occur rather quickly in 2017.
The Trump plan and the House proposal want to lower taxes on individuals – both aim to reduce the maximum rate to 33% from 39.6% currently and to reduce the tax brackets to 12%, 25%, and 33%. Currently, corporations pay a 35% tax rate, the highest in the industrialized world. Trump proposed a 15% corporate rate, while the House is at 20%. Further, there is arguably some $2.5 trillion in profits of US corporations held overseas. Trump and Congress are seeking to repatriate these assets by reducing taxes on such profits.
Tax Cuts? Fiscal Spending? Not So fast!
Keep in mind, the US deficit will need to be addressed. There is concern about how we would pay for all of this. Trump suggests that closing corporate tax loopholes (unspecified) and the notion that tax breaks will produce more taxable income will offset the tax cuts. Supply-side economics – I don’t think that worked the last time we tried it. My point here is: let’s not assume we can push spending and tax cuts without addressing the deficit.
Where Do We Go From Here?
While new trade issues with China, Mexico, and others, as well as immigration reform, could derail the economic and jobs agenda, it appears that the Trump administration intends to focus on fiscal stimulus and tax cuts first. The markets have fully baked-in a Fed Funds rate hike in December. Beyond December, with the potential backdrop of fiscal stimulus and tax cuts, there is an argument for a faster pace of Fed rate hikes to normalize the level of short-term bond market.
The combination of fiscal stimulus and tax cuts would spur the economy and could be inflationary. The first question, however: Is the 40 basis point “reset” in Treasuries that’s occurred this past week sufficient? I believe that it is sufficient, for now, and that we are likely to see markets stabilize here and wait for further evidence of policy proposals, actual changes and their ultimate impact on economic activity. Keep in mind, we currently have negative interest rates in Japan and Germany as well as slow/no-growth prospects and big debts worldwide. None of this changes over the near term. Similar to how BREXIT was overdone on the upside for bonds (downside for equities), the markets may well have over-interpreted how easily the US government can and will want to enact fiscal stimulus that further expands our deficit.
Keep in mind, however, that we started 2016 with interest rates pretty much where they are now – the 10-year Treasury was at 2.26% as of 12/31/15. In a broader context, this most recent move is a step away from very low interest rates. However, rates are still quite low, even at about 2.28%. I continue to see the interest rate markets favorable to borrowers and I don’t think borrowers should be holding out for rates to move lower at this point.