Pressure has been building in the bond market for a while. More than $1 trillion dollars in value was lost in bond markets around the world this week as the election results shocked investors. The status quo has clearly changed. Until now, economic growth in the U.S. has steadily improved, yet the Fed has not been willing to break from near zero interest rates due to the stagnating economies around the world and divergent central bank policy. Inflation was dead, or that was the belief. But such apathy over a critical economic element is very dangerous. Still, inflationary data has been sparse over the past few years, and inflation expectations have been dormant.
Even as unemployment in the U.S. declined, the participation rate declined in sync. Such that, wage pressures have only started to appear as the unemployment rate dips below 5%. But the green shoots are appearing for inflation. Core service prices have topped 3% for most of 2016. This is important as Services account for nearly 45% of real GDP. The data is getting there, but investors have been discounting it for one reason or another.
But that time seems to be over. When Donald Trump shocked the world to win the U.S. presidential election, everyone has had to take a step and reevaluate the data and expectations. Now, all of sudden, investors are starting to acknowledge what has been happening and extrapolating that Trump’s potential plans for infrastructure spending, defense spending, and trade protectionism may cause inflation to rise faster than previously thought just a few weeks ago. In turn, the new notion is that not only will rates likely rise correspondingly, but the pace of the rise is thought to be faster.
Therefore, the probability for a December rate hike has increased to 84% in Bloomberg polls. Also, with a Republican Senate and House to work with, Trump’s agenda is likely to have legs. If he is successful in his job creation goals, that should put more pressure on the labor market and likely lead to more wage gains.
The Fed has its work cut out for it – trying to battle rising inflation pressures while being cognizant of U.S. yields to global markets.
Source: Karunungan and Mnyanda, “Bonds Plunge by $1 Trillion This Week as Trump Seen Game Changer”, 11/11/16, Bloomberg.