(Bloomberg) — It took much of the first half of the year for Treasury investors to fall in line with a Federal Reserve signaling higher interest rates. As they weigh the timing of a second-half pivot, they also must contend with potential wild-card risks from a hotly contested presidential race.
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The US bond market has moved 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 approaches. With traders focused on each data point, extending the current run — Treasuries have not posted more than two consecutive months of gains since 2021 — will require continued evidence of a slowing economy and softer inflation that would increase the likelihood of a recession enlarge. interest rate cut as early as September.
Investors who were ready for six rate cuts in January are now more or less aligned with a central bank willing to sit on the sidelines for as long as necessary. Still, traders are pricing in a cut of at least one quarter point by year’s end and see a high probability of two. Whenever this happens, it will be a momentous event, potentially putting the government bond market on a path to normalcy after a record two-year period in which short-term debt yields have outpaced 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 on Thursday. Additional risks and uncertainties around the campaign trail could serve as a further catalyst to shake up the curve and reward investors who are betting on a return to a normal interest rate structure, a bet that has so far failed to pay off with the Fed on hold stood still.
“We can certainly expect to see some volatility in the markets leading up to the election,” said Gargi Chaudhuri, head of iShares investment strategy for the Americas at BlackRock Inc.
Right now, the US 10-year yield is currently trading around 4.25%, about half a percentage point less than the two-year Treasury yield.
Tellingly, neither Biden nor Trump appear willing to halt high-deficit spending, so under either administration, rising U.S. debt could lead investors to demand a higher premium for owning longer-dated Treasuries. On Thursday and beyond, attention will also focus on whether Trump signals he wants to test the central bank’s independence — or on the extent to which either candidate puts his foot in his mouth.
“There is a lot of concern that regardless of the outcome of the presidential election, the question around rising deficits and rising debt as a percentage of GDP is not something that is going to go away,” Chaudhuri said.
In a year of elections around the world, markets have already swooned over Mexico’s June vote, which could open the door to sweeping constitutional changes. France is soon heading for elections and that quick decision by President Emmanuel Macron has led to pain in the national debt.
“Think of the French election or the French announcement,” says John Madziyire, portfolio manager at Vanguard. “No one knows what the outcome will be. All you know is that, given the uncertainty, you have to start reducing your positions in French bonds.”
It remains to be seen whether government bonds will receive similar treatment as the election approaches – although for now the US is still buoyed by its status as a global haven. What is clear is that investors are already broadly wary of the two candidates’ propensity to widen America’s nearly $2 trillion budget deficit and rising debt burden — either through higher spending, lower taxes, or some combination thereof. These topics will likely be discussed on Thursday.
Outstanding government debt currently stands at $27 trillion, more than six times the size of the U.S. Treasury market in mid-2007. The nonpartisan Congressional Budget Office predicts that chronic deficits will push the U.S. debt mountain to about $50 trillion by the end of 2034.
As the Treasury sells more long-term bonds to finance the deficit, that supply will put upward pressure on yields. But beyond that, and even more troubling for some investors, is the idea that current long-term yields do not adequately reflect increased tax and related risks.
A Fed model of the so-called term premium for 10-year Treasuries – an approximation of the excess return investors demand for the risk of taking on longer-maturity debt rather than rolling over shorter-term securities – is currently in negative territory . At around -0.27%, this is well below the peak of 0.46% since October last year, when budget concerns were acute.
The risk is that the premium turns positive and widens as the election renews the focus on deficits and debt — something TD Securities cited in a note this week. And if one party gains control of the White House and Congress, the risk will be greater, market watchers say, because it would increase the chance that deficit-increasing legislation will pass.
“It doesn’t really matter, Democrats or Republicans, but if one party takes control, meaning deficits get bigger, then you should be comfortable shorting the long side,” said Ed Al-Hussainy, rates strategist at Columbia Threadneedle Investment . He sees “perhaps 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 approaches. But even here, fiscal factors could play a role.
One area where there does appear to be a difference between the candidates is Fed independence, a topic that has emerged as a campaign issue amid reports that some informal Trump advisers have floated ideas about possible changes that would make him more would give power over the central bank.
Forty-four percent of respondents to a recent Bloomberg Markets Live Pulse survey said they expect Trump will try to politicize the central bank or limit its power when he returns to the White House.
The reality is that a newly elected Trump will likely be limited in his ability to make major changes at the Fed outside of his appointment. But for some investors, even the thought of the central bank losing its independence means risk premia should be higher.
“After so many seemingly unthinkable things have happened in recent years, investors have learned that we can now never say never,” said Marion Le Morhedec, Global Head of Fixed Income at AXA Investment Managers SA.
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