Questions about the bond bear market and ‘Trump unchained’

March is shaping up to be a very different month than February. The angst in February was about inflation and bonds. But in March, signs of inflation have subsided and bonds have rallied. Now the worry is economic weakness and Fed overtightening. The yield on 10-year Treasury bonds hasn’t even hit 3% yet. Maybe the bond bear market Bill Gross and Ray Dalio foresee isn’t actually going to happen.

This is one of many topics I want to explore in today’s pre-market post. But let’s start off with the political economy for a second.

The dangers of Trump unchained

Politico has a good article on the recent changes in the Trump Administration. And this paragraph encapsulates it:

Trump is simply returning to who he’s always been, a one-man reality show who prefers to be surrounded by admirers who will praise and fawn over him and confirm that all his instincts are correct and brilliant and certain to succeed. The wonder is that anyone is surprised.

So forget about an administration of the best and brightest CEOs bringing business acumen to government. Instead think of the Trump administration as America’s being run like a closely-held private company. Let’s remember that Trump has never run a public company. And he has had autocratic control over decision-making at the Trump organization. At 71, he is not going to cede control at the White House.

We had a year during which Trump, new to office, listened to competing ideas and policy visions. He has rejected those now. And he now feels comfortable going his own way. In fact, he may feel trapped by the lingering investigations into his campaign. That gives him every incentive to take bolder and more aggressive action.

Trump and the politics of personality

Politico talks about more tariffs. And it talks about NAFTA ending. Those are two possible economic policy outcomes. But what about the geopolitical outlook? One thought I had concerns North Korea. Politico says:

And now Trump is even more fed up with strong-willed advisers who tell him he shouldn’t declare trade wars, or take it so easy on Russia, or decide on a whim to stage a summit with a nuclear-armed North Korean dictator, who it turns out might never have extended the invite in the first place.

What if North Korea confirms there was no invite? Kim Jong-un could simply say that he never invited Trump to a disarmament talk and cancel the projected meeting. That would make Trump look very foolish, having agreed to talks, only to be rejected. And knowing Trump’s personality, he would lash out quite aggressively were that to occur.

There are a lot of downside, black swan scenarios, that a ‘Trump Unchained’ can create.

The McCabe incident shows Trump at his most reckless

And the firing of Deputy Director Andrew McCabe reveals some of the pitfalls.

The sacking of Rex Tillerson was the beginning of ‘Trump Unchained’. But it was McCabe’s dismissal and the subsequent tweetstorm about McCabe and special prosecutor Robert Mueller which should raise eyebrows.

Note the part highlighted in yellow.

Trump tweets about Andrew McCabe and Robert Mueller

What Trump is saying is “it’s his word versus my word”. And he has lived his whole life taking a look before you leap approach with this tenet as his fallback. But the memos aren’t about establishing truth. They are about creating a contemporaneous account. They act not just as a third witness but as a vehicle which helps McCabe and Comey recall events more accurately. That makes them better and more believable witnesses.

Trump doesn’t appear to understand this. Moreover, his tweets about Mueller suggest he doesn’t understand that sacking him is different than sacking Comey, McCabe, or Tillerson. He’s used to just removing people under his control without any check on his power.

What if Trump sacks Mueller too? What then? Do Republicans abandon Trump, knowing Vice President Mike Pence can stand in? Do we have a constitutional crisis? Does a cornered Trump do something reckless on the international stage in reaction? There is a lot of uncertainty here.

The bond bear market call is touch and go

And this uncertainty comes just as signs of economic weakness have re-emerged. Bond yields have fallen on both sides of the Atlantic as a result.

The Eurozone benchmark German 10-year Bund yield has fallen eight basis points in March. 10-year Bunds were trading at a yield of 0.58% this morning. The high in early February was 0.81%. In the US, we are right around the 2.85% mark that yielded February’s equity market meltdown. After reaching 2.95%, it looked like we could continue to march higher to 3% and beyond. But the economic news has been poor and bond yields have declined.

Now, I have never bought into the bond bear market thesis. And that’s because I believed the selloff in bonds was cyclical, end of cycle stuff. The underlying numbers still show stagnant inflation and stagnant growth in the US and in Europe. If bond yields rise too high and too fast, it would choke off the recovery. And the disinflationary trends would re-emerge. Bond yields would then plummet.

Let’s remember that the recent economic news could be a pause in growth. So we could still see yields march higher. And they certainly have done on the front end of the curve. It’s just that the back end has rallied and yields have declined. Lower inflation and growth expectations are the cause.

What do the central banks do?

A lot of the future price action hinges on future monetary policy. Now, the Fed has been jawboning the market toward four rate hikes. What they are really doing is moving the market to the Fed’s policy guidance. The Fed is trying to take away the expectation of 2 rate hikes in 2018 that persisted. They wanted to move the market to three. Mission accomplished.

But now the market is a third of the way to four rate hikes.

federal funds futures - Bond bear market

Source: CME

That’s not where the Fed is though.

Will the Fed try and walk those expectations back? After all, it has been stressing the accelerated rate hike timetable. And the market is just reacting to that. I say no. Federal Reserve Chair Jerome Powell will reiterate the Fed’s three rate hike guidance for 2018. And he will leave the door open to a fourth, without explicitly guiding toward one. Powell will stress that the Fed’s actions are data dependent. But he will also say the headwinds have abated. That will guide to three with the possibility of four. But it also takes two rate hikes off the table as a likely outcome.

At the same time, some of the projections from the regional Fed Presidents might show a fourth hike for 2018, however. Let’s see what happens in two days’ time. There will be a policy statement, the dot plot of projections and a press conference.

Eventually the market will start to think more about the ECB though. Inflation remains well below target. And most observers don’t see a chance of a rate hike until well into 2019, as a result. So, despite a flood of euro area sovereign issuance, bond yields have fallen. And that’s not just for German Bunds but in the periphery as well, despite the uncertain Italian election results.

Mario Draghi is leaving the ECB though. And so we could see a change in direction. Bundesbank head Jens Weidmann is seen as a frontrunner for the ECB President’s job. And he has been quite a bit more hawkish than  Draghi in the past.

There is a lot to consider in the present economic and political environment. And as a result, there are a lot of potential outcomes for asset markets to consider as well. For those investors still short volatility, caveat emptor.

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