(Bloomberg) — Politics has helped breathe new life into one of bond traders’ most beleaguered bets, but only the Federal Reserve can give it a real turbo boost.
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The momentum behind Donald Trump’s presidential bid has pressured long-term Treasury bonds, sending their yields higher. The calculation is that the Republican candidate’s plans for tax cuts and and higher tariffs will ignite inflation and worsen US finances — even more so if the GOP gains control of Congress in a sweep.
This “Trump trade” has had the side effect of rewarding investors who have wagered that the bond market will return to normal after an unusual stretch when short-term yields exceeded those on longer-term debt. For the trade to really take hold, though, the Fed needs to deliver the next leg by cutting their target interest rate. That should set the stage for a sustained slide in the shorter end of the yield curve.
“The Fed moving rates lower is a big catalyst for the curve to steepen,” said John Madziyire, senior portfolio manager at Vanguard. “On the political side, any chance of a sweep in November means fiscal deficits come front and center.”
For the past two years, the bond market has been stuck in what’s dubbed an inverted yield curve, with two-year yields exceeding rates on benchmark 10-year debt. Many have been wagering on a reversal for nearly as long, which has mostly proved fruitless. But that’s changing.
On Monday, in the wake of the weekend’s assassination attempt on Trump, the yield on 30-year Treasuries surpassed the rate on two-year notes for the first time since Jan. 31, with investors weighing how re-energized Republican voters may influence the outcome of House and Senate elections and as the party began its convention on Monday.
“We need to take a step back because there is a long time between now and the election and things can change quickly,” Victoria Fernandez, chief market strategist at Crossmark Global Investments told Bloomberg television Monday. If the Trump-sparked steepening lasts it will have “a lot to do with what we see coming out of the convention,” and on whether the Trump campaign can attract moderate voters, she added.
Eyes on Fed
As this dynamic plays out, investors are turning their focus to how aggressively the Fed may cut interest rates this year as another key to moving back to a normal Treasury yield environment. A so-called steeper curve is typically powered by expectations of a Fed getting close to delivering rate cuts, and until lately the central bank has signaled high-for-longer policy. That’s limited the scope for a big decline on that end.
Now, a year after the central bank pushed borrowing costs to an upper level of 5.5%, this prospect is looking better. Inflation finally appears to be cooling and further progress on that front should see the Fed ease rates by September. All in all, traders see about 1.5 percentage points over the next 12 months.
Speaking Monday, Fed Chair Jerome Powell noted progress on inflation while declining to spell out the central bank’s future policy shifts, and reiterated that an “unexpected” weakening in the labor market would trigger rate cuts.
Traders will focus on retail sales Tuesday and what that says about consumer health and the Fed policy path. As of now, the market is fully pricing in a quarter-point cut for September and around 60% odds for a third easing by December. Economists at Goldman Sachs Group Inc. said Monday that they even “see a solid rationale” for Fed policymakers to cut rates as soon as their meeting this month.
While two-year yields are still higher than their 10-year peers, the difference between them has narrowed to 23 basis points from as much as 51 basis points in late June.
Vineer Bhansali, founder of the Newport Beach, California-based asset-management firm LongTail Alpha has been in a steepening position – through derivatives structures that help to offset the costs of putting on the trade. He says the economic data and Fed outlook have also been key with the Trump odds to the steepening tone.
“I think Powell really wants to cut rates now,” said Bhansali. “That’s driving the front end. And as far as the back end, it seems the market sees now pretty much no chance that anyone can compete with Trump.”
Burned Before
A steepener trade is expensive and the cost of funding that position can burn a trader’s pockets, hence the stop-and-go nature of the bet in recent months.
“That’s the problem with the Treasury trade now,” said Steven Englander, strategist at Standard Chartered Bank in New York. “Given how investors have been burned on short bond trades, they may want to make sure that the Trump trade is the dominant one before going short fixed income again.”
Bhansali is undeterred. “The steepener hasn’t been very good for a while but this month it’s been behaving very beautifully,” he said. “Once it moves, it tends to really move.” From here, he expects the spread between the two-year US note and 30-year Treasury bond to turn decisively positive and ultimately widen by as much as 2 percentage points,
For others, the return to normal isn’t so much about Trump, which means the biggest moves may be yet to come.
“My bias is that this is more about inflation slowing and the labor market slowing and the Fed coming into play more than it is about Trump,” said Tim Graf, head of EMEA macro strategy at State Street Global Markets. “The inflation that everybody assumes comes from a Trump presidency, I would submit is not as obvious.”
–With assistance from Matthew Burgess, Ye Xie and Nicholas Reynolds.
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