More spending, more inflation

To finance that deficit, the U.S. government, through the Treasury and its agencies, will have to sell bonds, thus driving down their prices. For financial advisors who want to avoid spilling clients’ blood, a defensive strategy is essential.

The potential size of the deficit is impressive. The nonpartisan Committee for a Responsible Federal Budget has estimated that Trump’s policies would add US$11.5 trillion to the U.S. national debt over the next decade. That, in turn, will increase total borrowing costs. And, indeed, in the first week following his election, the market indicated it anticipates rising interest rates.

The stocks of life insurance companies and banks both rose: higher rates may allow lifecos to price their products more attractively by earning more on premium income; banks will be able to increase the spreads between their borrowing and lending costs.

The era of falling U.S. interest rates, which have been headed down since the early 1990s, will be ended by the Trump administration’s spending. Rising rates also are anticipated as a result of increases in short-term interest rates administered by the Federal Reserve Board.

The rise in interest rates is happening already. In the first week following the Nov. 8 election, U.S. interest rates rose sharply. The rates on U.S. 10-year treasuries increased from 1.70% to 2.30%. Just four months ago, the U.S. 10-year treasury yielded a humble 1.30%. Government of Canada 10-year bond yields rose by 20 bps following the U.S. election, while the yield on 10-year German bunds rose to positive territory with a 0.30% yield to maturity.

The immediate effect of the rise in short rates will be to flatten the yield curve – a precursor of a slowing economy. Then, inflationary expectations would express themselves in rising long-term rates, says Jack Ablin, executive vice president and chief investment officer with BMO Harris Bank N.A. in Chicago. More debt to finance, and more anticipated inflation to cover that debt will push up interest rates. However, the question is: “By how much?”

U.S. Treasury debt is like no other. The world appears to have an insatiable appetite for all treasury bonds, especially the 10-year T-bond. That appetite implies supply alone will not drive up rates very much, says Chris Kresic, senior partner and head of fixed-income at Jarislowsky Fraser Ltd. in Toronto.

“Supply of bonds does not dictate the direction of interest rates,” Kresic explains. “Inflation and growth are the more important influences. Moreover, if Trump runs the trillion-dollar deficits he promises and all that supply jacks up rates, [Trump’s policy] would be self-defeating. In the end, the yield curve will move up and steepen on inflationary expectations.”

That situation is happening. Says Charles Marleau, senior portfolio manager and president of Palos Management Inc. in Montreal: “The yield curve will steepen under President Trump. If he does what he says – that is, bringing corporate taxes down from 35% to 15% – there will be a huge impact on the economy. Infrastructure spending will be stimulative. There is more chance that inflation will pick up with a Trump government.”

Laying out a bond strategy in the first few weeks of an anticipated new and radically different U.S. presidency is speculative. However, given the mandate of the Trump government to boost employment through infrastructure spending and to cut tax rates, higher bond interest rates seem inevitable.

The risk in holding high- duration long bonds is clear. Shorts minimize price risk at the cost of income.

But bond ladders are opportune. One- to five-year U.S. government bond ladders offer both safety and yield. As rates rise, maturing bonds will be rolled into new and higher-yielding issues. The ladders’ downside is limited by the rollover mechanism.

For example, BlackRock Inc.’s iShares Core 1- to 5-Year USD Bond ETF (symbol: ISTB), which has a 0.08% management expense ratio, generated a 2.79% return for the 10 years ended Oct. 31, 2016. This ETF is composed of about half treasury and U.S. agency bonds with a large holding of investment-grade debt, especially financial services bonds.

For the expected pickup in inflation, inflation-linked bonds are appropriate. iShares 0- to 5-Year TIPS Bond ETF (symbol: STIP) generated a 2.20% total return for the 12 months ended Nov. 30, 2016. Both swooned in the week following the election, but each will raise payouts with rising rates and inflationary expectations.

The essential question: “Will money flee stocks and take haven in bonds, or will money flee bonds for other assets, such as commodities, that are close reflections of inflation?” On the theory that populist governments are eager to spend, Trump is likely to find ways to dispense money.

“In the short term, bond markets will be negatively impacted,” Kresic explains. “The Canadian bond market should outperform the U.S. market, given our relatively weaker growth outlook. Corporate bonds, in general, should also outperform government bonds as credit quality improves. “But,” he adds, “over the long term, interest rates will stay relatively low, restrained by weak economic growth and modest population growth.”

In other words, a return to the double-digit rates of the 1980s and early 1990s is not in sight. A fixed-income strategy anticipating moderate rate rises and accelerating inflation is just prudent. IE

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