The growing prospect of a Trump presidential victory is making yield curve steepeners an attractive bet as growth will likely slow and inflation quicken under such a scenario, according to Morgan Stanley.
The US presidential debate has strengthened the possibility of Donald Trump’s re-election, and this will sharpen the focus on the former president’s immigration and tariff policies, the bank’s strategists wrote in a June 29 note. Bond traders are bracing for a similar outcome, with the yield discount of 10-year notes over two-year securities shrinking the most since January last week.
“There has been a clear relative shift in the probabilities of President Trump winning over President Biden” since the debate, Morgan Stanley strategists including Matthew Hornbach and Guneet Dhingra wrote in the note. “The sharp shift of probabilities in favor of President Trump may be a unique catalyst that makes curve steepeners attractive.”
The recalibration in bets may complicate the outlook for the US government bond market after it capped a two-month winning streak last week. Traders are pricing in the risk of slower growth and faster inflation as Trump has vowed to deport undocumented immigrants and ramped up threats of increased tariffs against China.
“The market now has to contend with rising probabilities of changes in immigration and tariff policies in an economy where growth has already been cooling, making the market more likely” to price in more US interest-rate cuts, the strategists wrote. “Higher prospects of a Republican sweep, amid growing focus on deficits, could put upward pressure on long-end term premiums.”
The strategists recommended adding two-year/20-year steepeners in Treasuries.
Higher tariffs and the possible deportation of migrants would both be negative for US economic growth, Morgan Stanley analysts said in a presentation last month. The hit to the economy would likely encourage the Federal Reserve to cut interest rates, reducing short-term yields.
The Congressional Budget Office has estimated that immigration will generate a $7 trillion boost to gross domestic product over the next decade.
US Treasury Secretary Janet Yellen said last month that Trump’s proposed tariffs would raise costs for consumers and weigh on American businesses. Faster inflation would be bad news for longer-maturity debt as it diminishes the value of their fixed payments over time.
The outcome of the presidential debate has triggered a flurry of calls from analysts on how to position for a Trump victory. For its part, Barclays Plc is recommending that investors buy inflation hedges in the US Treasury market.
Nomura Securities Co.’s Naokazu Koshimizu sees a Trump administration favoring fiscal expansion and a weak dollar. This, along with the preference for a dovish Federal Reserve chair, would lead to a steeper US yield curve.
“It would be difficult to cover the fiscal expansion in the event of a Trump administration with additional tariffs alone, and the possibility of issuing more bonds will increase,” the Nomura senior rates strategist wrote in a note Monday. “If inflation flares up again and the Fed policy rate remains high, an increase in interest payments is also expected to lead to a wider fiscal deficit.”
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