By James Mackintosh
Investing is about two things: Deciding what is likely to happen, and comparing it to what's priced in to markets. The discussion about what's likely to happen under President Donald Trump has dominated all media since his election, and every investor has their own view. What's important, then, is to compare it to what's priced in.
One chart cuts through all the chatter. The yield curve in the all-important Treasury market tells a story of Trumpflation, a boost to both growth and inflation lasting a few years, with little long-term impact on the real economy.
"People have pushed up their expectations about growth, but it's more of a cyclical view than a structural view," said Jan Hatzius, chief economist at Goldman Sachs.
The yield curve compares bond yields at different dates, and has steepened sharply as 10-year Treasury yields rose much more than those on 2-year bonds since the election. This happens when investors expect faster growth and higher inflation, and has a positive feedback loop to investment, as investments further in the future carry a higher expected reward.
Longer-dated bonds tell a quite different story, though, with the curve flatter the further in the future it goes. The 10-year yield has risen much more than 30-year yields, which suggests little change in long-run expectations for productivity or inflation.
The hope of a cyclical boom is reflected across equity markets, although the details of the new administration's policies create more noise at a stock level. Cyclical companies such as car makers and airlines have easily beaten the S&P 500 since the election, while defensive companies -- those better able to ride out a recession -- have lagged behind, and, in the case of utilities, lost money.
The yield curve may be one of the most important measures in finance, but even the question of what the market expects is open to interpretation.
The most obvious drawback is the starting point. The curve has steepened a lot, but the starting point was deeply depressed. Last summer investors were concerned about a grim future with little growth and the risk of deflation, and the yield curve was the flattest since 2007. Even after the recent steepening, the gap between 10-year and 2-year Treasurys is only just above the postcrisis lows reached in 2012 and 2015.
Michael Gapen, chief U.S. economist at Barclays, says the curve isn't steeper because any Trump stimulus -- assuming it comes -- is arriving when the economy is already close to full employment.
"It might just hasten the end of the cycle because it comes so late in the cycleit doesn't really change the long-term outlook," he said.
If Mr. Trump's stimulus plans are implemented by Congress -- a big if -- they might end up boosting inflation more than real growth. That is reflected in the rise in the bond market's implied inflation expectations, known as break-even inflation. It is back above 2% for the next 10 years for the first time since 2014.
A proxy for expected real growth, the after-inflation yield on 10-year Treasury inflation-protected securities, rose fast after the election before giving back some of its gains following the Federal Reserve's December rate increase. Yet even at its December peak of 0.74% plus inflation, it wasn't quite back to where it stood a year earlier, and was nowhere near the pre-2008 norms.
One interpretation: Investors think the downward pressures on growth and inflation from the aging population are greater than any likely productivity gains from cutting red tapeor improving infrastructure. The most Mr. Trump can do is make America a little bit greater than it otherwise would be, not the catchiest of campaign slogans.
Some critics argue that the 30-year Treasury is a flawed measure of hopes for growth. It isn't very heavily traded, and government decisions on issuance, plus price-insensitive demand linked to pension obligations, can be as important as beliefs about long-run growth. This may be true, but it's also obvious that if investors truly believed Mr. Trump would deliver a big and permanent boost to growth or inflation, few would want 30-year bonds at a yield of just over 3%. It may not be perfect, but it's a good enough measure.
Knowing what the market as a whole is pricing creates opportunities for investors who have a strong view of what Mr. Trump will achieve. More growth, more inflation or more policy chaos all have scope to move the market by a lot. The problem is for those who have little idea what the man in the White House represents; the usual diversification between shares and bonds offers little protection against the risk of a trade war, when both could suffer as inflation rises and profits fall.
Write to James Mackintosh at James.Mackintosh@wsj.com
(END) Dow Jones Newswires
January 30, 2017 10:48 ET (15:48 GMT)
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