The short answer is that the election results are, of course, affecting interest rates. However, recent movement in the interest rate markets also has a lot to do with the economy.
Since our nation spoke on which leaders we would collectively prefer to see guide our country for the foreseeable future, interest rates have launched higher. Take the 10-year U.S. Treasury note for example. The yield on this note closed at 1.86% on Election Day, and catapulted to 2.23% over the following week. A move of this proportion, especially to the upside, is certainly a rare event. Furthermore, it brings both concerns and hopes for different parts of our country.
First of all, let’s address why the results of Election Day matter so much for interest rates. The magnitude of the move in rates, particularly in such a short amount of time, primarily reflects how surprised investors were by the outcome of the election. Outside of my Uncle Tony, nobody was pricing in a high probability for a Trump presidency. In fact, most of the prognosticators that we follow had the odds of a Clinton presidency somewhere between 65-80%. We could argue as to why the polls and predictions were wrong, but that is not the point of this article. For the sake of this story, let’s just all agree that the financial markets were not expecting what ended up happening.
Throughout his campaign, Donald Trump made several arguments that would lead one to conclude he wants to see interest rates move higher, and that he will use his available resources to influence a change. The biggest question, in regards to interest rates, is how Trump will influence the Federal Reserve. The U.S. President is in charge of appointing the Chair of the Federal Reserve. At present, Janet Yellen is the Chair of the Federal Reserve, and she has mostly been an advocate of lower interest rates. She carries with her a continuance of the same ideology from her predecessor, Ben Bernanke. Their shared belief is that the U.S. economy remains in a fragile state, and that we must maintain lower interest rates for the sake of overall growth. Trump does not agree with this approach, and has openly opposed this theory. He has made statements that imply he sees this strategy as part of an agenda to redistribute wealth from savers to borrowers. Whether you agree with one side or the other, it is not difficult to surmise a scenario where Trump replaces Ms. Yellen. However, perhaps the market has jumped the gun on how quickly Trump will be able to execute this transition? Ms. Yellen’s current term of office extends through January 2018. Unless Trump attempts something radical by replacing her in the middle of her term, which would be highly controversial and would take Congressional approval, it seems that Yellen will remain a heavy influence for at least another year and change.
What will be more influential in the more immediate future, in my opinion, are Trump’s ideas on government spending and taxation. Trump has repeatedly stated he would like to ramp up infrastructure spending while also slashing taxes for basically all U.S. workers and corporations. The market has quickly priced in the probability that Trump will successfully institute these plans, and investors are also assuming these policies will lead to an increased government deficit, increased economic growth, and higher inflation.
However, anytime certainty is priced into the financial markets, we tend to raise an eyebrow. Yes, the Republicans have control of Congress and a slim majority in the Senate. But, many of the Republican leaders on both sides have been elected by their constituents to lower government spending and reduce our nation’s debt load. Therefore, it might be too quick for the market to assume that these spending plans will be passed without at least some resistance. Again, whether you agree with the plans or not isn’t the point. We simply feel that history would suggest that investors often feel regret after making decisions based on the assumption that something will get done in Washington without a few snags along the way.
Ok, enough about the election. We need to talk about the other major factor driving interest rates: the economy. Let’s not forget that the 10-year U.S. Treasury note reached a nadir of 1.36% in July of this year, a nearly 40% decline from where the benchmark rate began the calendar year. More importantly, at least for this discussion, the rate rallied 50 basis points, or half a percent, from that day in July to Election Day. This particular leg of the rally in interest rates had nothing to do with politics. The Federal Reserve had already begun planting the idea that higher interest rates were on the way. It is now widely believed, and has been even before the election, that the economy is now firm enough to warrant a gradual increase of interest rates by the Federal Reserve. While nobody is accusing the U.S. economy of being anything fantastic at this point, as far as overall growth and inflation are concerned, things have become incrementally better, at least according to the metrics which the Federal Reserve uses to make decisions.
So, what do we make of all of this information? I believe the conclusion is that, as usually is the case, the markets are assuming too much, and have reacted on pure speculation. First of all, this recent increase in interest rates is not cause for alarm. The 10-year Treasury yield is still below where it began the year, and far below historical norms. Investors should exercise caution before massively repositioning their portfolios. Let’s all take a deep breath. We do not know what will happen, and until we do, the markets will be acting on pure speculation.
Most importantly, we maintain the stance that interest rates cannot move sustainably higher without the backing of strong economic growth. The casualties of higher interest rates without growth behind it would be too severe. Of course, we would all love to see stronger economic growth and subsequently higher interest rates, regardless of what gets us there. Therefore, we come away from the recent happenings with the same feeling we had before: we’re hopeful and optimistic that economic growth will return, and that we will break free from the doldrums of a low-growth and rock-bottom interest rate world. But, until we actually see some real action and the resulting proof that it is working, it is our feeling that we must remain patient, and admit that it remains far from a slam-dunk that interest rates will continue on their recent trajectory.