A global bond selloff spread from the U.S. to Germany on Wednesday, with analysts and traders pegging the action to new details on President Donald Trump’s tax reform.
With further clarity on the exact policies Trump wants to see passed, the recent progress could placate investors who have complained that his legislative proposals have been too vague. If Trump manages to push his tax plan through Congress, it could stoke inflation pressures, eroding demand for Treasurys.
See: Text of tax-reform framework from President Donald Trump and Republicans
Yet the severity of the selling pressure seen mid-week suggested other forces were at work. After all, bond investors have been blasé about the progress of tax reform after seeing Trump have trouble pushing its legislation through Congress, even as the Republicans control the House, Senate and White House. It’s not clear if the current proposal has a higher chance of passing.
Market participants said the Federal Reserve’s recent hawkish stance and investors who are overextended on bets wagering yields would slip lower helped to unwind the bullish outlook for long-ended Treasurys. The 10-year bond yield TMUBMUSD10Y, +1.47% climbed more than 7 basis points, in its largest single-day jump since March. 1, according to WSJ Market Data.
Bond prices move inversely to yields.
The Federal Reserve’s most influential members, New York Fed President William Dudley and Fed Chairwoman Janet Yellen, have justified the central bank’s hawkish stance in recent speeches, arguing that inflation would eventually hit its 2% target and that raising rates now would be prudent in the face of tight labor markets, which if left unattended, could drive inflation higher.
“We’ve got so many central bank speakers in the last two days, no one really sounded dovish. There’s tinges of coordinated central bank discussions,” said Marvin Loh, senior fixed-income strategist at BNY Mellon.
The momentum appears to have shifted in favor of the bond bears. Earlier in September, speculators’ net position in 10-year Treasury futures was bullish, meaning the majority of investors were betting on long-dated yields to rise rather than fall. But in a more recent survey of investor positioning by JP Morgan on Sept. 25, the share of fund managers, central bankers and hedge funds holding more long-dated Treasurys compared to the benchmark index’s allocation had fallen.
“Investors have been caught offside by the Fed’s recent hawkishness despite low inflation,“ said Gene Tannuzzo, senior portfolio manager at Columbia Threadneedle.
But last week, when the Fed first displayed its hawkish feathers in the policy statement, long-dated yields shrugged. Though most of the members voted for a rate hike in December and the dot-plot forecasts stayed unchanged for 2017 and 2018, only the shorter two-year note yield TMUBMUSD02Y, +0.55% rose sharply. This caused the yield curve, a graph charting maturities against yields, to flatten.
It’s why some analysts think the strength of the selloff, reflected by bond-buying in the long end of the curve, was overdone.
“Ultimately, it might just be the yield curve flattened too much, too quickly,” said Loh.
Investors still feel much of Wednesday’s trading was driven by tax reform, if only because expectations for Trump’s proposals had fallen so much that any sign of progress would have led to a backlash in Treasurys. Andy Richman, a fund manager for SunTrust Advisory Services, said investors were complacent and had priced out tax reform altogether.
The bear steepening of the yield curve, when longer-dated yields rise much faster than shorter-dated yields thanks to stronger inflation expectations, suggested it was hopes for tax cuts instead of Fed hawkishness driving Wednesday’s action, said Eric Stein, co-director of global income at Eaton Vance.
The U.S. Treasurys market has been linked to the ebb and flow of expectations for fiscal reform. Since Trump’s inauguration on Jan. 20, the downtrend in the benchmark 10-year yield reflected a “tremendous unwind of optimism around fiscal policy,” said Tannuzzo.
Trump’s approval ratings, a proxy for his legislative priorities getting enacted in Congress, have fallen in line with the slipping 10-year Treasury yield, according to Goldman Sachs’ analysts.
See: Why Goldman thinks the so-called Trump trade is still alive in the bond market
For the most part, expectations are close to bottoming out. Even after new details of Trump’s proposals were unveiled Wednesday, some analysts said the mid-week selloff would dissipate in the way that the post-election jump in yields unwound over the course of 2017.
“The proposal is simply a more exacting version of Trump’s tax reform ‘wish list’ that has been floated several times. It’s always folly to presume that precision implies accuracy and we fear that’s what the markets are currently trading,” wrote Ian Lyngen and Aaron Kohli, interest-rate strategists at BMO Capital Markets.
Nonetheless, a few investors are cautiously optimistic that the so-called reflation trade is back on track. Earlier in the year, Treasury yields had jumped in anticipation that Trump’s pro-growth agenda would push growth and inflation higher. Though the White House has had trouble repealing and replacing Obamacare, which has taken up much of Trump’s energies, certain aspects of his tax plan might prove palatable to Democrats, said Stein.
“There’s a decent shot of passing in some semblance of the current form,” he said, highlighting that the proposed corporate tax cuts from 35% to 20% would attract less opposition from across the aisle.