The Day After In Bondland

“Destiny is not a matter of chance; it is a matter of choice. It is not a thing to be waited for; it is a thing to be achieved”

– William Jennings Bryan, 1899 (Democratic candidate for president in 1896, 1900, and 1908)

William Jennings Bryan was never elected president, losing to William McKinley twice and to William Howard Taft in 1908. However, he was the most successful Populist candidate for president… until last night. We now have a William Jennings Bryan with much better financing.

With a victory that upset polls and took until late into the night to be finalized, Donald Trump completed his mission of becoming the 45th president of the United States.

What follows is a quick update of the election and what it means to bond markets.

Treasury Rates

Leading up to the election, it was believed that a Trump victory would result in a “flight to quality” before government spending on infrastructure could accelerate interest rates. That was not the case, as 30-Year Treasury bond yields increased the most this year and the 10-Year reached an eight-month high founded on the market’s belief that the Republican candidate would increase spending to boost the economy. Throughout his campaign, Trump pledged to lower taxes and increase spending on infrastructure, both of which could intensify inflation and increase the budget deficit.

The 10-year Treasury climbed 20 basis points to 2.06% while the 30-year jumped 25 basis points, the largest increase in over five years, reaching 2.87%. Shorter-dated Treasuries rallied before backing off amid the belief that a Trump win would decrease the likelihood that the Federal Reserve will hold rates steady at the December meeting. The market-implied chance of a December rate increase dropped from 82% to 47% before rebounding back into the mid-70s. The initial drop in the rate-hike probability was fueled by the belief that the economy could not withstand higher rates under Trump. While we believe that the Fed will continue to maintain a cautious approach to raising rates, our expectation is that they will still move rates higher in December. We believe that the Trump campaign’s commitment to a higher growth rate for the economy will eventually lead to more borrowing, a higher interest-rate construct, and perhaps a higher level of inflation. We felt that to some extent this pattern would also have accompanied a Clinton victory, and so we have shortened duration in anticipation of higher interest rates.

Municipal Bonds and Infrastructure

On the municipal bond front, we certainly think that the Trump victory will result in infrastructure spending on a larger scale than a Clinton presidency would have done. Many factors are unclear, but we have been operating on the assumption that a Trump administration will invest roughly $1 trillion in a long-term infrastructure program, with a combination of government borrowing and tax credits to attract private investment.

Trump has promised to reduce marginal tax rates. Our best guess is a 33% top rate instead of current 39.6% The fate of the Obamacare tax now paid by families earning more than $250,000 is unclear; but an educated guess is that if Obamacare is overhauled, this tax may be gone as well. That would hurt municipal bonds at the margin because of lower tax rates. However, longer tax-free bonds have held at over 90% yield ratios to Treasuries, and AA and A rates bonds are still well over 100%. With a backdrop of rising Treasury rates, tax-free bonds should be cushioned somewhat, given their current cheaper relative value. In addition, the elimination of many deductions and exemptions may leave tax-free bonds as one of the few safe havens.

If Trump is able to get policies of lower taxes and less regulation through Congress, these could help our already-chugging-along economy and be a positive for municipal and corporate credit quality in general. Congress is now in Republican hands, which may bode well for these policies. If companies are allowed to keep a larger portion of their earnings in this country, there may not be a need for an extra tax on the importation of goods from domestic companies’ factories in foreign countries. An improving economy and prospects for positive growth, along with the ability to keep more of our hard-earned money, may cause more people to enter the workforce. Improved corporate earnings and growth could fuel the stock market and improve investment returns. Improved investment returns would help the growth of retirement and pension funds – a sorely needed development. Of course there are sectors that will face challenges, such as hospitals that have been ramping up to comply with Obamacare regulations.

Infrastructure investment was always expected to get a welcome shot in the arm if either candidate won, as both emphasized the great need to invest in our crumbling infrastructure. This investment potentially includes programs to leverage local funds. The need for infrastructure improvements and the rush to take advantage of low interest rates, coupled with the current lack of federal help, have encouraged jurisdictions to take infrastructure development into their own hands, resulting in $70 billion in bond ballot measures, the majority of which are for school construction, transportation projects, and some water and sewer funding. As of this writing, the largest single ballot measure passed was $9 billion for schools in California, and nationally it looks like approximately half of the infrastructure ballot initiatives were approved.

The anticipated increase in infrastructure funding is also good for the municipal bond market because of expected matching funds or other types of programmatic support. The spending on infrastructure would be a positive to economic growth, which again would benefit municipal credit quality. If the federal government aggressively funds infrastructure development, there will be an impact on inflation expectations.

We are entering a period of uncertainty as the election results are sorted out; but with majorities in both houses of Congress, President-elect Trump will have cooperation in implementing his programs.

As we sit here on post-election day 1, we believe we are heading to higher interest rates (from an extremely low level), and we expect to see more in the realm of municipal finance, but tax-free bonds will still be the cornerstone. Any drop in marginal federal tax rates may be offset by the elimination of some deductions.

We will have some longer pieces in the coming week as we dissect the bond markets and reaction to the election.

by Cumberland Advisors