NEWS ANALYSIS
While U.S. stock markets soar to record highs after the passing of the Trump administration’s Tax Cuts and Jobs Act, bonds face a rough ride.Interest rates in advanced economies are being pushed higher by strengthening global growth, prospects for higher inflation, and less bond buying by central banks. The United States has the additional dynamic of a ballooning deficit to fund $1.5 trillion in tax cuts, which may double its supply of bonds in 2018.
“The dramatic increase in U.S. fixed-income supply in 2018 is a significant risk to markets,” said Deutsche Bank chief international economist Torsten Slok in an email to clients.
The U.S. 10-year bond yield is hitting levels it hasn’t since the fall of 2014. The 2.60 percent yield level has been breached and the direction it’s headed unquestionably seems higher. The Canadian 10-year bond yield has followed suit, albeit in reference to a 2.20 percent yield.
More Buyers Needed
The U.S. Joint Committee on Taxation estimates that the new tax cuts will add $135 billion to the deficit in fiscal year 2018 and $280 billion in 2019.TD Securities estimates the U.S Federal Reserve’s reduced bond buying will add $230 billion to the deficit in 2018. This will need to be funded by Treasury issuance, which TD Securities expects to be concentrated in maturities below five years.
As the supply of bonds increase, the amount of additional yield investors require to own the bonds generally increases.
What’s important for the health of the stock market is that credit spreads remain stable.
Blackrock’s global chief investment strategist, Richard Turnill, says rising global inflation expectations are already fuelling higher bond yields.
He points to the recent move higher in U.S. 10-year yields as being mainly driven by the market’s expectation for higher inflation—at their highest in three years.
The Fed penciled in three rate hikes for 2018 in its December forecast. Accordingly, the U.S. 2-year yield recently moved above 2 percent for the first time since the fall of 2008 and now is slightly higher than the S&P 500 dividend yield.
Slok says the supply of U.S. government bonds will almost double to $1 trillion in 2018. BMO deputy chief economist Michael Gregory says the U.S. Treasury has to find buyers for more than $500 billion of debt.
“Investors should spend less time looking at U.S. economic fundamentals and more time on where a doubling in demand for U.S. fixed income can come from,” Slok said.
The U.S. bond market is getting nailed at both ends. While a rapid rise in rates is unlikely, a gradual increase certainly appears to be.