Bond Market in Step With Fed Is About to Slam Into US Election

Liz Capo McCormick and Michael Mackenzie

Wed, Jun 26, 2024, 4:00 AM6 min read

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(Bloomberg) -- It took much of the first half of the year for Treasury bond investors to fall in line with a Federal Reserve signaling higher-for-longer interest rates. Now, as they weigh the timing of a second-half pivot, they must also contend with potential wild-card risks from a hotly contested presidential race.

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The US bond market has clawed its way close to breakeven, thanks to two straight months of gains that have left the benchmark Treasury index down just 0.15% for 2024 as July beckons. With traders focused on every data point, extending the current run — Treasuries haven’t been able to eke out more than two consecutive months of gains since 2021 — will require sustained evidence of a slowing economy and softer inflation that would increase the chance of a rate cut as soon as September.

Investors who were primed for six rate cuts in January are now pretty much aligned with a central bank willing to stay on hold as long as needed. Still, traders are pricing in at least one quarter-point reduction by year-end and see a high probability of two. Whenever it happens, it will be a momentous event, potentially setting the Treasury market on a path toward normalcy after a record two-year stretch when yields on short-term debt have exceeded their longer-term counterparts.

Into this mix comes the US election cycle, with the first presidential debate between President Joe Biden and his predecessor Donald Trump set for Thursday. Added risks and unknowns around the campaign trail may serve as a further catalyst for jolting the curve and rewarding investors who are betting on a return to a normal rate structure, a wager that has failed to pay off so far while the Fed has stayed on hold.

“Certainly, we can see going into the election a little bit of volatility going into the markets,” said Gargi Chaudhuri, head of iShares investment strategy, Americas at BlackRock Inc.

As of now, US 10-year yields currently trade around 4.25%, about half a percentage point less than those on two-year Treasury notes.

Tellingly, neither Biden nor Trump appears willing to arrest high deficit spending, so under either administration spiraling US debt may cause investors to demand a higher premium to own longer-dated Treasuries. Attention on Thursday and beyond will also focus on whether Trump indicates a desire to test central bank independence — or the extent to which either candidate puts his foot in his mouth.

“There is a lot of concern that regardless of the presidential election outcome the question around rising deficits, rising debt as a percentage of GDP, that is not something that’s going away,” Chaudhuri said.

In a year replete with elections around the globe, markets have already swooned in the wake of Mexico’s result in June that is seen potentially opening the door to sweeping constitutional changes. France is heading for elections soon and that snap decision by President Emmanuel Macron has sparked a bout of pain for its government debt.

“Think about the French election or the French announcement,” said John Madziyire, portfolio manager at Vanguard. “No one knows what the outcome’s going to be, all you know is you need to start reducing your positions in French bonds given that uncertainty.”

It remains to be seen whether Treasuries will receive similar treatment as the election nears — although the US remains supported by its global-haven status for now. What is clear is that investors are already broadly wary of the two candidates’ propensity to add to the US’s near $2 trillion fiscal deficit and ballooning debt load — either through higher spending, lower taxes, or some combination. These topics will likely come up on Thursday.

Treasury debt outstanding currently totals $27 trillion, more than six times the size of the US government debt market in mid-2007. The nonpartisan Congressional Budget Office projects that chronic deficits will lift the US debt pile to about $50 trillion by the end of 2034.

As the Treasury sells more longer-dated bonds to fund the deficit, that supply will put upward pressure on yields. But beyond that, and more worringly to some investors, is the idea that current long-term yields don’t adequately reflect heightened fiscal and related risks.

A Fed model of the so-called term premium for the 10-year Treasury note — an approximation of the extra yield investors demand for the risk of taking on longer-term debt rather than rolling over shorter-term securities — is currently in negative territory. At about -0.27%, it’s well below a peak of 0.46% from last October, when fiscal concerns were acute.

The risk is that the premium will turn positive and widen as the election renews the focus on deficits and debt — something TD Securities cited in a note just this week. And if one party gains control of the White House and Congress, the risk will be magnified, market watchers said, because it would increase the chance of deficit-enhancing legislation moving through.

“It doesn’t really matter, Democrats or Republicans, but one party taking control, which means deficits get worse, then you should be comfortably shorting the long end,” said Ed Al-Hussainy, a rates strategist at Columbia Threadneedle Investment. He sees “maybe another 50-plus basis points of upside in terms of term premium.”

For many investors, economic data and Fed policy remain the primary focus even as the election looms. But even here, fiscal factors may play a part.

One area where there does seem to be a difference between the candidates is Fed independence, a subject that has emerged as a campaign issue amid reports that some informal Trump advisers have floated ideas about possible changes that would give him more power over the central bank.

Forty-four percent of respondents to a recent Bloomberg Markets Live Pulse survey said they expect Trump to seek to politicize the central bank or limit its power if he returns to the White House.

The reality is that a newly elected Trump would likely be limited in his ability to make big changes at the Fed beyond appointments. But for some investors even the thought of the central bank losing independence means risk premiums should be higher.

“After so many seemingly unthinkable things that unfolded over the past few years, investors have learned that we can never say never now,” said Marion Le Morhedec, global head of fixed income at AXA Investment Managers SA.

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