The election of Donald Trump as the next US President has led to a significant regime shift in the outlook for US growth, inflation and Treasury supply. The prospect of substantial fiscal stimulus has led to a bear steepening of the Treasury curve, significantly higher spot and forward breakeven inflation rates, higher stock prices and a stronger dollar. Stocks have also likely benefitted from the possibility of lower corporate and capital gains taxes and prospects for deregulation in a number of industries. Meanwhile, markets have also discounted a somewhat steeper path for Fed policy, and market expectations for a December rate hike remain firmly in place.
One of the more remarkable elements of the market reaction to Trump’s victory has been the rise in the Treasury term premium, and what this suggests about the likely stance of fiscal policy going forward. According to one estimate published by the Federal Reserve Bank of New York, the term premium rose by close to 30 basis points in the two trading days after the election, accounting for almost the entire move higher in the nominal 10-year Treasury yield over this period (please see the Chart of the Week). Even the 2013 Taper Tantrum never saw such a pronounced rise in the term premium over a two-day period. What is behind this sudden move?
Changes in the term premium can reflect shifts in a number of factors, including perceptions of sovereign credit risk, the outlook for publically available supply (including prospects for central bank asset purchases), the inflation risk premium, and changes in risk sentiment that impact demand for government bonds. Our initial interpretation is that the rise in the term premium reflects investors assigning a higher probability to the risk that a large portion of any tax cuts and spending initiatives will be unfunded and would require substantially higher Treasury issuance. Of course, such stimulus would boost growth in the short run at a time when the economy is already close to full employment, and hence the inflation risk premium has also likely risen as well; that is, investors are assigning higher odds to inflation outcomes that are above their modal forecasts.
What is surprising about expectations for increased Treasury supply is what it reveals about investor expectations for the balance of power between the incoming administration and fiscal conservatives in Congress, as well as the commitment of Republicans to balanced budgets. Presumptive House Speaker Paul Ryan and others have long favored paring tax cuts with significant cuts to mandatory and discretionary spending in order to reduce the size of the government and to improve the nation’s long-term debt sustainability. It would appear that Republican control of both chambers of Congress and the Executive branch represents a golden opportunity to turn this vision into reality. But investors seem to be discounting a very different outcome, that the President-elect will not prioritize deficit reduction and that Congressional Republicans will ultimately go along with unfunded tax cuts and new discretionary spending, including on infrastructure and the military.
For a number of reasons this seems an appropriate judgement, at least until we hear more from Ryan and other Congressional Republicans. First, many Republicans will seek the administration’s support in future elections, including the mid-terms, and ceding to the president-elect’s fiscal priorities is one way to ensure such support. Second, Trump has shown disdain for establishment politicians, including from within his own party, and will not hesitate to publicly criticize them if they do not fall into line with his plans. Indeed, it is still unclear if Ryan will have the necessary support of the administration to retain the Speakership. Finally, the natural proclivity of any party in power is to spend, and Republicans are no different from Democrats in this regards. Looking back to prior Republican administrations, including those of Ronald Reagan and George W. Bush, reveals that sticking to fiscal prudence is easier said than done. Should we see signs over the coming weeks that the resolve of Congressional Republicans on fiscal discipline is wearing thin, the rise in the term premium will have more room to run.Download to read more