U.S. Bond Yields Are Going Higher

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Includes: BIL, DFVL, DFVS, DLBL, DLBS, DTUL, DTUS, DTYL, DTYS, EDV, EGF, FIBR, FTT, GBIL, GOVT, GSY, HYDD, IEF, IEI, ITE, PLW, PST, RISE, SCHO, SCHR, SHV, SHY, SST, TAPR, TBF, TBT, TBX, TBZ, TLH, TLO, TLT, TMF, TMV, TTT, TUZ, TYBS, TYD, TYNS, TYO, UBT, UST, VGIT, VGLT, VGSH, VUSTX, ZROZ
by: Shareholders Unite

Summary

Stocks have reacted more forcefully to the Trump win compared to bonds.

There are sound economic reasons to argue that it should be the other way around.

Unless the Fed intervenes, but that would be bad for stocks.

Conventional wisdom has it that expectations of Trump's policy agenda are responsible for a rather epic rally in stocks. This reflationary policy mix consists of:

  • Tax cuts
  • Deregulation
  • Additional spending in infrastructure and defense
  • Economic nationalism

Even Fed Chairwoman Janet Yellen was in on this (from MarketWatch):

I think market participants likely are anticipating shifts in fiscal policy that will stimulate growth and perhaps raise earnings.

That is, the market seems to expect a substantial upturn in economic growth and company earnings growth. In as much as it is these expectations that are driving the stock rally, this is a little odd.

Why?

For starters, people with knowledge of the legislative process know that much of the impact of a reflationary effort is at least a year away. Before measures can get through Congress and actually have some impact on the ground, we're likely to be well into 2018.

The second point is that while stocks are going from strength to strength, bonds, after an initial post election sell-off, have basically stalled.

That is, investors seem to think that Trump's reflationary efforts are likely to lead mostly to higher real growth and corporate earnings growth, much less in wage and price inflation.

Of course, the alternative explanation is simply that Trump's reflationary promises aren't really what's driving stock prices (which we, in part, argued here), but we'll leave that for the moment.

We argue that it is odd to think that a Trump reflation will mostly lead to higher real growth, less so to higher inflation.

Given the constraints of the production capacity (potential supply growth), the economy cannot really grow beyond 2% (actually a little less). Those supply-siders like Stephen Moore and Larry Kudlow who tout the 4% growth under Kennedy and Reagan and argue we can do that again haven't considered the following figure:

The combined growth of the labor force and productivity growth is what makes up potential growth. As you can see, this was much higher in the Kennedy and Reagan years. Today they constrain growth to just under 2%.

We addressed the question whether this is reversible in another article (here). In summary, the growth of the labor force is determined by long-term demographic developments.

Under Kennedy and Reagan we had baby boomers and women coming onto the labor market, today we have these baby boomers retiring and no further increase in female labor force participation.

What's more, over half of the labor supply growth comes from net immigration, something which Trump's immigration and deportation policies are likely to curb, lowering labor supply growth further (especially in industries like construction and agriculture).

A rise in productivity needs a sustained increase in business investment. Many seem to think that the corporate tax cuts will achieve that, but we have substantial doubts here:

  • Business investment isn't really sensitive to the cost of capital. Indeed, the cost of capital has been very low for years without this leading to a substantial increase in business investment.
  • Business isn't lacking funds to invest, profits are at record highs, interest rates are still very low, cash balances are bulging.

We still think that real growth could increase, but not through supply measures but via demand measures instead, that is, by "stressing the system."

While business investment might not be very sensitive to the cost of capital, it is much more sensitive to output growth (or the expectation of output growth). This is the so-called acceleration theory of investment.

This kind of acceleration really happens through "stressing the system," that is, it is akin to overclocking your processor, running it above its normal speed limit.

In an environment in which resources are scarce as the economy is already close to full employment, hitting the accelerator through stimulating demand enlists more availability of resources through the price mechanism, basically they are bid up which stimulates new supply.

The inflow into the labor force and business investment increases. The latter has both a demand and a supply component, so this creates a bit of a virtuous cycle. But the operating mechanism is higher prices, it's the latter that activates increased supply.

That is, the economy is likely to overheat, with prices rising. Of course the Fed will have something to say about this (pretty soon, in all probability), but that means higher rates and higher inflation and we'll get the situation in which fiscal policy is very expansive and monetary policy is trying to limit the nasty side effects.

An ultimate bond implosion

It's not hard to imagine what such a policy combination would do to US bonds; a summary:

  • A reflationary budgetary policy in the context of an economy near full employment is likely to overheat the economy, that is, produce more inflation and less real growth.
  • If the fiscal efforts lead to more inflation than growth, the deficit is going to blow up significantly.
  • Fed hikes to cool the economy off will add to the rise in bond yields as the short-end of the maturity spectrum will be lifted.

The only big uncertainty in this picture is what will happen to the dollar. It is likely to rise, which will mitigate the overheating of the economy. However, there are a host of potential other factors that could influence the trajectory of the dollar, like Trump's possible turn to protectionism.

Conclusion

The stock market is discounting a considerably more rosy picture in the bond market. Stocks are pricing in a considerable amount of higher real growth and earnings growth.

While that is entirely possible, even likely, we think that most of Trump's reflationary efforts are going to show up in higher inflation and worsened public finances. Both of these should scare bondholders, but their reaction has been fairly muted so far.

While this isn't a scenario that will play out immediately, as the effects of Trump's reflationary efforts will not materialize before 2018, it's curious why stocks are discounting so much more and earlier compared to bonds. While this can last a while, it is likely to reverse at some point.

It is of course entirely possible that the bond market trusts the Fed in keeping inflation in check, or that no real reflationary effort will emerge.

But a more active Fed should be bad for stocks, given the growth constraints that are not easily moved, so one way or another we expect some relative reversal between the fortunes of stocks and bonds.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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