Get Ready For A Tectonic Shift In The Bond Market
Everyone grew up hearing the story of the shepherd boy who frequently lied to the local townspeople about the threat of wolves on his flock.
Time after time, the people rushed to his aid after hearing shouts that wolves were threatening his sheep. However, each time, the townspeople found the shepherd had lied about the presence of wolves.
#-ad_banner-#Eventually, the townspeople become immune to the boy’s calls.
When real wolves appeared and the boy cried for help, the people of the town assumed the cries were another hoax and ignored him. Later the townspeople realized the cries were real, but it was too late. The wolves killed the sheep, and in one version of the story, the shepherd, too.
Centuries later, we have a similar refrain…
Aesop’s story of “The Boy Who Cried Wolf” reminds me of Michael Hartnett’s message from five years ago. Mr. Hartnett is the chief investment strategist for Bank of America Merrill Lynch who famously coined the term the “great rotation.”
If you’re not familiar with the term, Mr. Hartnett believed that a great rotation out of bonds and into stocks was just beginning in 2011. He sounded the alarm. But it wasn’t true.
Since then, there have been more than 17 other legitimate calls of a “great rotation” taking place in the bond markets. They have all been wrong.
This time, the movement out of bonds and into stocks is gaining traction. And by all appearances, it’s real this time.
Since November 8, 2016, almost $2 trillion has flowed out of the bond markets. During the same time, U.S. stocks have hit record highs.
That’s not a coincidence…
Why The Tectonic Shift?
In a word, Trump.
You see, for the first time since the financial crisis there is talk of fiscal strategies that will create inflationary pressures and grow the nation’s GDP in real terms.
That’s because President-elect Trump isn’t interested in allowing the Federal Reserve to do the heavy lifting of economic growth with monetary policy as Barack Obama has done. Instead, he plans to use fiscal policies to grow the economy.
Of course, deficit spending combined with lower taxes is highly inflationary — and likely means that ultra-low yielding bonds will disappear. But with Trump’s almost fearless use of debt to create wealth for himself and others, he could plow ahead with inflationary spending on infrastructure.
This means his impact on the bond market will be secular in nature — that is, it will be felt for years or even decades. Already, we’re seeing the impact. The 10-year bond is about 50 basis points higher than the night of the election — and Mr. Trump doesn’t even take office for another 6 weeks.
A Case For 100-Year Bonds?
Assuming Republican lawmakers don’t object to Trump’s spending plans (an unlikely event), the bond market could see other changes in the future. Like a 100-year bond.
As interest rates continue rising, the government runs into significant funding problems. You see, even without any infrastructure spending, the costs of existing programs like Medicare and Medicaid will push the national debt to $45 trillion in 20 years’ time, according to the Congressional Budget Office.
In today’s low-rate environment, $45 trillion in debt will cost the nation about $750 billion a year in interest payments — making it one of the most expensive budget items. But consider this…
If interest rates return to their historic levels, interest payments will exceed $1.5 trillion! And there is no way the government can afford those payments. Which means the government needs to seek an alternative to the typical long-term bond.
Enter the 100-year bond.
Given Trump’s familiarity with debt as a tool, it’s not unthinkable that the U.S. government could mimic Austria’s use of a 70-year bond whereby they locked in 1.5% interest rates for two generations. Given the global demand for U.S. government bonds, the Treasury could easily stretch that out to 100 years.
Even if the Treasury had to pay a higher interest rate than the 30-year bond, the rate would still be roughly half the median long-term borrowing rate through U.S. history. At the same time, institutions with long-term investing goals would be eager to buy 100-year bonds.
This would cement the end of the bond rally that started in 1981, while also guaranteeing the secular change in the bond market.
100-Year Bonds Will Benefit Equity Investors Too
Trump’s pronouncements to rebuild our decaying infrastructure have been a boon to bank, small-cap, commodity, and industrial stocks. The structural shift away from the bond market will bring a flow of new capital into these sectors and the equity market on the whole. But the renewed bullishness for equities won’t be applicable to all classes of stocks.
Risks To Consider: It’s still too early to say with certainty that President-elect Trump will follow through with his promises to boost fiscal spending and deregulate the financial sector. Should the more conservative Congress object to Trump’s plans, a slow-growth, low-rate environment will continue.
Action To Take: Keep an eye on shifting trends in equity markets as Trump transitions into the presidency. Work to identify the sectors that will benefit most from these changes, as well as strong individual companies within them. As always, check StreetAuthority for the latest insights and analys
Editor’s Note: It’s everywhere, in everything from cell phones and handheld games to solar panels and pharmaceutical drugs. And prices are set to soar! Check out our 10 most shockingly profitable stocks of 2017…