Bond Markets May Be at Risk from Inflationary Forces Outside the Fed's Control

Investors continue to worry about potential inflationary risks, with uncertainties such as the upcoming November 5 presidential election adding to their concerns. These factors haven't been fully factored into the bond market, and policymakers may have limited tools to address them. As of Tuesday, prediction markets were showing a slight edge for Republican nominee and former President Donald Trump over Democratic nominee, Vice President Kamala Harris, in the race for the White House.

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A recent Wall Street Journal survey indicated that economists expect inflation, interest rates, and federal deficits to rise more under Trump’s policies than under Harris’s. However, a separate survey conducted by Bloomberg found that the inflation and economic growth outlooks might be similar, regardless of who wins the presidency.

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Despite some developments in the Middle East that led to a more than 4% drop in oil futures, which contributed to a decline in Treasury yields, inflation concerns persisted on Tuesday. The 10-year Treasury yield fell to 4.037%, while the 30-year yield finished at 4.328%, both declining for the second consecutive session.

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Bond market volatility remains high, as reflected by the ICE BofAML MOVE Index, which tracks swings in Treasury yields. While it eased slightly from the highs seen earlier this month, particularly after the 10-year Treasury yield broke above 4% for the first time since July, the index remains near its highest levels of the year.

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There are growing questions about whether the U.S. is entering a new phase where inflation may accelerate beyond the Federal Reserve's ability to control it. Factors such as the shift towards more protectionist trade policies and the government's inability to address the growing national debt—now approaching $35.7 trillion—could contribute to these concerns. The budget deficit, hovering around $1.9 trillion, adds to the pressure.

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According to Eric Vanraes, head of fixed income at Eric Sturdza Investments in Geneva, the U.S.'s debt situation is becoming unsustainable. Vanraes, whose firm manages $1.2 billion in assets, noted that a potential Trump victory and competition from other more attractive bond strategies are not positive signs for long-term bonds. He explained that Trump's policies are likely to exert upward pressure on long-term interest rates, primarily due to increased inflation expectations. However, Vanraes added that if Trump were to win but Democrats controlled Congress, his program might not be fully implemented. For bond markets, the composition of Congress is just as important, if not more so, than the outcome of the presidential race in determining long-term yields.

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Rising inflation poses significant risks to long-term bondholders, as it can lead to selloffs in the Treasury market. These selloffs drive down the prices of government securities and cause spikes in yields that current bondholders miss out on. Additionally, inflation risks can spill over into other areas, such as currency and stock markets.

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In terms of market sentiment, some experts believe inflation is likely to be a more persistent issue moving forward. Matt Rowe, head of portfolio management and cross-asset strategies at Nomura Capital Management, suggested that higher inflation could become the new reality. He attributed this partly to the inflation of risk asset prices and the diminishing returns from globalization-driven efficiency. Rowe emphasized that if the U.S. continues to move towards more domestic production and a more insular economy, there will be limits to what interest-rate policy can achieve in controlling inflation.

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In commentary shared with MarketWatch, Rowe stated that the global economy had benefited from years of favorable trade policies and accommodative monetary policy. However, as globalization retreats and countries adopt more protectionist stances, the economic environment is becoming more complex and challenging.

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For months, discussions around the "Trump trade" have circulated among financial market participants. These discussions focus on how expectations of a Trump victory can influence financial markets. However, these views lost some momentum in September after Harris was declared the winner of the first televised debate against Trump. At the same time, the Federal Reserve cut interest rates by half a percentage point, reinforcing the growing confidence that inflation was sustainably returning to the Fed's 2% target.

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Inflation concerns have also sparked renewed attention on the "neutral" rate of interest. This theoretical rate is the level at which monetary policy neither stimulates nor constrains the economy. Some economists now believe that the neutral rate may be higher than previously thought. This has raised fears that if the Federal Reserve cuts interest rates too aggressively, it could trigger another wave of inflation.

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Although inflationary pressures are expected to ease in the short to medium term, both Harris and Trump have proposed fiscal policies that could exacerbate the U.S.'s already stretched debt and deficit levels. These policies may also contribute to longer-term inflation pressures. Anthony Saglimbene, chief market strategist at Ameriprise Financial, emphasized that the outcome of the election and the post-election composition of Congress will play a crucial role in shaping the U.S.'s fiscal outlook and inflation trajectory.

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Saglimbene noted that while investors are confident that near-term inflation pressures will ease, they are also aware of potential long-term inflation headwinds. This dynamic is likely contributing to the recent rise in 2-year and 10-year Treasury yields, despite expectations of further interest rate cuts by the Federal Reserve.

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On Tuesday, U.S. government bonds saw gains, while all three major stock indexes— the Dow Jones Industrial Average, S&P 500, and Nasdaq—closed lower. The Dow and S&P both retreated from their record closing levels reached on Monday.

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