US treasury yields rise as Trump presidency becomes more likely + More

Euro dollar rally past 1.08 unlikely to last due to ongoing eurozone issues

by Faruk Imamovic
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US treasury yields rise as Trump presidency becomes more likely + More
© Getty Images/Spencer Platt
  • • Comments from ECB officials and still sticky services inflation in the Euro area should have strengthened the EUR. But it is weakening as traders worry that either the populist-right or far-left will have undue influence on fiscal management in France.
  • • The best case situation is that we'll return to a status quo characterized by a high degree of apathy around Euro area growth, and around political cohesion within and between countries in the Euro area. It's hard to see a EUR/USD rally past 1.08 that becomes durable.
  • • It's no coincidence that UST bond yields have risen alongside the prospect that Donald Trump will win the US presidency. Traders' perceptions are that the Trump 2.0 policies on immigration, tariffs, and taxes would bring higher inflation, a tighter Fed, and so higher UST yields.

After a strong session yesterday in Europe and modest gains in the US, stock indexes are lower this morning, and giving up almost all of yesterday's gains. For one, comments by key ECB policymakers at the ECB's symposium in Sintra, Portugal, have taken forward rates higher on the EUR OIS curve, with the implied number of Deposit Rate cuts by the ECB being trimmed further. From projecting nearly two cuts last week (roughly -45bps of easing), traders have walked that back to -40bps this morning. 

In addition, the caution by Lagarde and Lane was seemingly justified by a preliminary Euro area CPI inflation report (for June, here), wherein the year-over-year core HICP (CPI) came in 0.1% higher than the consensus, remaining at 2.9% (2.86% unrounded, and 0.34% month-over-month). Within the segments, services inflation remained sticky, as was expected at 4.1% year-over-year (the same level as May), although some observers thought that it was boosted in June by the European football championships.

France-Germany

But while the above events might be associated with strength in the EUR this morning, the EUR/USD has weakened again (by -20 pips), and that's coming alongside the France-Germany 10-year sovereign spread widening again today, after having narrowed on Monday. Evidently, traders are still nervous (as they should be) about the prospect of the populist-right or far-left having undue influence on France's fiscal management following the 2nd round of the new National Assembly elections on July 7.

Although an absolute majority of 289 seats may be difficult to attain for the populist-right National Rally (RN), the party would still have the highest likelihood of leading a government because it will win roughly 260-280 seats, making it unlikely that any government could be formed without the RN if a government is indeed formed. Also, with 265 seats won, the RN would be within range of forming a working government if other parties on the right (e.g., Les Republicains) or their deputies either back an RN government (i.e., abstain from voting out an RN prime minister in motions of censure), or make a deal with the RN for a mixed government (possibly with a non-RN Prime Minister). That's why in the betting market, the probability that the RN forms a government (that is recognized by the French electoral authority) may be relatively low (20-25%), but the prospect that the Prime Ministership goes to the RN (presumably to its president, Jordan Bardella) is high, at 50-55%.

On the Left, traders may be getting a bit too worried about President Emmanuel Macron's willingness to force many centrist candidates from his Ensemble coalition to drop out from the 2nd-round vote in order to reduce the chances that the RN candidates succeed in winning a plurality on Sunday (see here). So far, at least 190 candidates have dropped out — 123 from the left and 64 from Macron's group in a tactical maneuver to reduce the National Rally's chances. But that has raised the prospect that a cross-party government of the center and Left could be formed to avoid having a minority government, effectively bringing the elements of the far Left into a decision-making capacity.

In any case, we still doubt that the EUR/USD will gain more ground until we know the result of the 2nd round of France's election and the actual distribution of seats in the National Assembly. But even after that, political analysts will continue to lament the political polarization in France and Germany, and economists will warn about the inflationary implications, over time, of the high debt burdens in France, Italy, etc. I.e., the best-case situation is that we'll return to a status quo characterized by a high degree of apathy around Euro area growth, and around political cohesion within countries and across the Euro area. It's hard to see a EUR/USD rally past 1.08 that becomes durable.

EUR/USD
EUR/USD© Getty Images/Matt Cardy
 

Why higher US yields?

Probably because Trump's probability of winning has risen, and because his domestic and international economic agenda involves a few key things that can be deemed to be more "inflationary" than Biden's agenda would be:

  • • First, restricting immigration more effectively and implementing the removal of undocumented immigrants) would reduce the low-cost labor supply, putting upward pressure on wages, at least in the market's imagination. (Of course, this ignores that it would also reduce upward pressure on aggregate demand.) The number of non-citizen Latin American immigrants who arrived in 1980 or later (the cohort that substantially overlaps with undocumented immigrants) was relatively stable prior to Covid-19, but it has increased by more than >2.5mn since then to amount to roughly 15.4mn. Its not inconceivable that Trump's plan contemplates removing 1mn workers from the workforce, therefore, if he focuses on recent undocumented arrivals.
  • • Second, while both Trump and Biden see tariffs as a key tool of diplomacy, the heavy import tariffs (60%) on China and on the rest of the world (10%) proposed by Trump are seen to cause import prices to rise. The estimates are difficult to ascertain, given substitution effects, but Moody's has said that the tariffs would be associated with a 0.7% increase in CPI inflation in the year after the tariffs are enacted. Moreover, retaliation and deglobalization would be likely too, whereby resource misallocation would act as a negative (inflationary) supply shock.
  • • Third, neither Trump nor Biden has a credible plan for bringing the US federal deficit under control, and neither previous administration (Trump 1.0 or Biden 1.0) was able to do so, anyway. It is unlikely that a Biden 2.0 administration or a Trump 2.0 administration would see new spending stimulus on the order of the American Rescue Plan Act of 2021 (with its direct payments to eligible recipients) or the Infrastructure Investment and Jobs Act of 2021. But it is likely that Trump would extend the Tax Cut and Jobs Act of 2017 beyond its sunset period (2025), thereby keeping the deficit higher than it otherwise would be under Biden (who would allow the TCJA to sunset). That would increase the supply of bonds and be fiscally stimulative.

Trump may have a natural political inclination to have the Fed cut its policy rate, but traders could be reasoning that the Fed will remain autonomous and keep the policy rate higher than they otherwise would under the Trump policy agenda. And even if the Fed is pressured to keep policy rates low during Trump's administration, the Trump policy agenda still causes policy-rate hikes during the post-Trump years (i.e., post 2028). Alternatively, the UST yield curve is steepening to offer a wider buffer for bond buyers because of the uncertainty around the path of short-term rates (a term premium) that Trump's policies will cause.

The Bottom Line is that it's no coincidence that UST bond yields have risen alongside the improved prospect (since late last week) that Donald Trump will win the US presidency. Because of Trump's policies on immigration, tariffs, and taxes, Trump 2.0 should be associated with higher inflation, a tighter Fed, and higher UST yields.

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