Phil Grossfield's Blog

A LITTLE EXTRA…

Why Bonds Fell – The Assumptions & Uncertainty Of Trumpenomics

trumpWHY DID BONDS FALL?  THE ASSUMPTIONS & UNCERTAINTY OF TRUMPENOMICS.  Let me see if I can give you some talking points with your clients on why bonds fell so dramatically since the election results were announced.  The main concern is rising inflation.  Bonds hate inflation so when it’s on the rise traders will sell-off bonds. The truth is, nobody really knows what Trump will do except Trump himself, and I don’t think he really has a definitive plan at this point. I believe he approaches these sorts of issues with the mentality that whatever it is he’ll make sure it’s fixed…that he’ll figure it out…just like he figures out how to fix issues within his businesses. There is no room in his mind for failure…he’ll just get it done. But based on his comments made during the campaign, we expect him to (1) repeal free trade agreements with other countries and (2) lower taxes while simultaneously increasing government spending for infrastructure, i.e., airports. This would undoubtedly influence an accelerated change in the Fed’s monetary policy.
  1. Elimination Of Free Trade Agreements.  Per the Constitution, Trump as President will have the authority to negotiate trade agreements with foreign countries. He has said that he intends to repeal the free-trade agreements that are currently in place because they allow other countries to take advantage of the U.S.  These free-trade agreements have allowed countries to trade without heavy regulations or tariffs (taxes).  So, if Trump repeals these trade agreements, then products that we purchase from other countries will be more expensive because of the newly placed regs and tariffs. When products become more expensive it’s called rising inflation, and Bonds hate inflation. Therefore, traders have sold off bonds because they expect rising inflation if Trump goes through with eliminating free trade agreements. When traders sell off bonds, our rates/pricing worsen.
  2. Lowering Taxes While Increasing Government Spending.  Trump promised to lower taxes while simultaneously increasing government spending for infrastructure, i.e., airports, etc. So, the question economists have been asking is where is this money going to come from to build infrastructure if we’re going to lower taxes?  The only logical source, unless Trump knows something we don’t, is that we will have to borrow the money and increase our debt.  We currently owe about $14 trillion which is about 76% of our GDP. Think of the debt-to-GDP ratio in mortgage terms we understand, “DTI.”  So, our DTI if you will is about 76%.  I know that sounds like a lot since we work in mortgages where the cut-off is typically 50%. But compared to other countries, our DTI of debt-to-GDP is relatively low. For example, the UK, Germany, France, Italy, and Canada all have higher debt-to-GDP than the U.S.  And Japan has a whopping 260% debt-to-GDP…way more than 3 times the U.S.  Because our bond debt is relatively low compared to our GDP, our bonds look attractive to other countries.  But if we increase that debt to raise capital for infrastructure, then the debt-to-GDP will go up making our bonds less attractive.  When bonds are less attractive, the price will be worse. When traders anticipate the price of bonds being worse, they sell. When traders sell off bonds, our rates/pricing worsen.
  3. fedThe Fed Will Accelerate The Reduction Of Buying Bonds.  The Fed had been buying bonds for the last several years in order to keep interest rates low. It’s what is often referred to as “the artificial market.”  Ideally, the Fed should not be involved in buying bonds…the free markets should dictate when bonds are bought and sold. But the Fed employed monetary policy of buying droves of bonds to help out our flailing economy during the recent depression. For this reason our rates/pricing have been artificially low for almost the entirety of the Obama administration. The problem is that this is not sustainable. At some point, and many argue we’re way overdue (including me), the Fed needs to back off and let the free market operate. That’s why you’re hearing all this news about the Fed raising interest rates.  Traders know that eventually rates will increase and the Fed will reduce its involvement to buy bonds. But that timeline was expected to go on for years and therefore simply raising interest rates is in itself not enough to influence traders to sell off bonds.  But now that Trump is going to be President, and we expect him to raise our debt-to-GDP (DTI – see #2 above), the Fed will likely accelerate the reduction of buying bonds.  Some argue the Fed might have to stop altogether after the 2017 year!  That fear is what caused traders to sell off bonds. When traders sell off bonds, our rates/pricing worsen.

    To take it a step further, traders are considering that there will be less refinances. If rising interest rates are accelerated, then the number of refinances will diminish faster. That should make perfect sense to you. If not, then let me explain…when a borrower refinances, they pay off the existing mortgage. As an investor of these mortgages, the Fed would get an influx of cash from the payoff and that cash would be used to buy more bonds which in turn would help keep interest rates low. But if rates go too high, refinances will fall off significantly, meaning there will be less payoffs of existing mortgages and less cash flow for the Fed to buy more bonds.  It exasperates the problem.  My analogy is an ice-covered lake. As the temperature rises, the surface melts and creates cracks in the ice. These cracks will feed down to the bottom of the ice carrying the warmer water from above which accelerates the melting. Traders realize this and have been selling off bonds as a result. When traders sell off bonds, our rates/pricing worsen.

FOR ALL THESE REASONS, traders sold off bonds. It took a whole year to get the bond prices high and our rates/pricing so aggressive. But because of these concerns after Trump was elected, bonds lost all the year’s gains in less than 2 weeks.  As always, this is intended to give you talking points with your borrowers. REMEMBER, borrowers are more likely to do business with you if they trust you. By understanding what’s going on, and being able to communicate the same, you instill trust. I hope all of this helps. If my explanations are unclear, or if you disagree, I would love to hear from you.
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