How Trump Has Changed Inflation Expectations

The news of Donald Trump's victory sent the futures markets roiling long after the markets and polls closed on Nov. 8. At one point, the Dow futures were down more than 900 points as Trump's lead strengthened in key swing states. But the equity markets pared those losses, and even closed higher on Nov. 9, as investors scooped up stocks, believing earnings would benefit and inflation would increase as a result of lower government regulation, lower tax rates, and increased government spending on infrastructure programs. In fact, stocks have been racking up small, steady gains since the election--and the volatility we had been bracing for hasn't materialized. (Not yet, anyway.)

But the bond market is a different story altogether. It's been anything but quiet: Investors started selling bonds, spooked by the prospect of higher inflation and higher interest rates. (The CME FedWatch Tool currently shows a market-implied probability of over 90% that the Fed will raise rates at its December meeting.)

When investors sell bonds, it drives their prices down, and yields head higher. (To understand more about "bond math," see this article.) The Bloomberg Barclays US Agg Bond Index is down about 1.9% for the one week through Nov. 14, and the intermediate-term bond category has shed 1.8% in aggregate, and yields have jumped--the 10-year Treasury yield rose from 1.88% on Nov. 8, to 2.07% on Nov. 9. (post-election), and the 30-year Treasury yield jumped from 2.63% on Tuesday to 2.88% the following day. In the ensuing days, yields have kept rising.

What's Responsible for The Yield Spike? Trump's promised infrastructure spending and fiscal stimulus is a likely culprit for the steeply rising yields. In his election victory speech, Trump reiterated his goal to "rebuild our infrastructure."

Morningstar director of economic analysis Bob Johnson thinks inflation could be in the offing because both tax cuts and infrastructure building will be "part of the equation" in a Trump presidency. "More spending combined with less revenues is going to tend to push the deficit up... And historically, deficits have helped move up inflation and have generally caused rates to move higher. So, we've had this short-term dislocation situation where the Fed wants to help, but certainly you've got this tax policy and spending policies, if implemented, would likely raise inflation and cause higher interest rates."

How Have Expectations Changed? There are a few market-based measures of inflation that help shed light on investors' inflation expectations.

One is the "breakeven inflation rate." This measure compares the yield on nominal Treasuries to the yield on Treasury Inflation-Protected Securities of a similar maturity to estimate inflation expectations.

Ten-year breakeven inflation, which is calculated by subtracting the yield on a 10-year TIPS from the yield on a 10-year nominal Treasury bond, jumped from 1.73% on Nov. 8, to 1.82% on Nov. 9, and continued to climb through Monday. If actual inflation exceeds the break-even inflation rate over the holding period of the bond, the TIPS bond would provide superior returns to a similar-maturity conventional Treasury. So, if you're buying a TIPS bond today, you are assuming that inflation would have to average at least 1.82% per year for the next 10 years, or else you would have done better to invest in a traditional Treasury bond. (This analysis is overly simplified, because it ignores certain premiums that compensate for the risks associated with holding Treasuries and TIPS.)

Another market-based gauge of inflation is the 5-year, 5-year forward inflation expectation rate, which also shows an increase in expected inflation. It jumped from 1.89% on Nov. 8 to 1.97% on Nov. 9, and was over 2% as of Nov. 10. As the name implies, clumsily, this is an expectation of inflation over the five-year period that begins five years from today. Some prefer this measure to the breakeven inflation rate, because longer-term inflation expectations tend not to be as affected by cyclical factors.

What Does This Mean for Bonds? Whether investors continue to jettison bonds in the near term is anyone's guess, but if interest rates and inflation expectations are headed higher over the medium term, it's likely that bonds will feel some more pain. But before you decide to swap out your bonds for stocks, take stock of why you have a fixed-income allocation in the first place.

Stock-market volatility, though it hasn't materialized so far, could happen at any time. For many people, a bond allocation serves as their portfolio's ballast; in effect, bonds can help anchor a portfolio that has a sizable equity exposure. (The correlation between high-quality bonds and equities is fairly low, meaning that bonds have the potential to gain--or at least not lose very much--during stock market sell-offs.)

"Higher yields are ultimately good for bond investors, (although higher inflation obviously isn't)," said Sarah Bush, Morningstar's director of fixed-income research. Overall, Bush urges investors to look at bond funds in the context of their broader portfolio, and to try not to be overly influenced by short-term market fluctuations.