Trump will burst the bond bubble

After months of bluster, the administration finally appears on the verge of passing a significant piece of legislation that could affect the bond market.

874-D.Trump-634
The bluster is over and tax cuts are on the cards but will it boost stocks?

"The chance to slash the US corporate tax rate to 20% from 35% seems much more pleasant to contemplate than nuclear war," says Randall Forsyth in Barron's. So it's no wonder Wall Street decided to ignore North Korea's latest, more powerful missile and concentrate on the package of tax cuts and reforms produced by the US Senate last Saturday. After months of bluster, the administration finally appears on the verge of passing a significant piece of legislation.

The key elements of the package are the corporate tax cut, a discounted tax rate on foreign profits to encourage firms to bring their overseas cash piles home, and the closure of several loopholes. The bill still needs to be reconciled with the version proposed by the House of Representatives, which should occur by Christmas. The package will add yet more debt to America's fast-growing pile: another $1 trillion or so over ten years.

The tax package could give stocks additional momentum, although given the endless discussion of the topic over the past year, the odds are that most of the boost is priced into America's now extremely expensive equities. UBS Wealth Management is pencilling in a $10 per share boost to S&P 500 profits, so the index's constituents will earn a total of $151 per share in 2018 rather than $141.

Still, earnings have rebounded strongly in any case following a dip in 2015-16, and half the sales of the index's constituents are made abroad, so the global outlook is just as important as the US one. And while Bank of America Merrill Lynch expects a boost to US growth of 0.3% in 2018 owing to the tax bill, the world economy "is growing robustly, and in unison, for the first time since the financial crisis", as Rob Cox notes on Breakingviews.

The effect on bonds, however, could be far more significant. This package comes as the economy "is already at or close to capacity", says Hamish McRae in The Independent. Growth reached an annualised 3.3% in the third quarter, and the labour market is very tight. Adding fuel to the fire now could lead to a nasty jump in inflation. That would be a shock to absurdly overpriced bonds, especially since everyone thinks inflation has disappeared and central bankers almost always fall behind the curve.

We were in exactly this situation in the 1960s, adds John Plender in the Financial Times, with inflation apparently vanquished, the labour market tight, and fiscal and monetary policy extremely loose. Inflation had reached 6% by 1970. Today, long-term interest rates are already creeping up as the growth outlook has improved. But this tax package "will definitively put an end" to the 36-year Treasury bull market.

Recommended

Bonds
Glossary

Bonds

A bond is a type of IOU issued by a government, local authority or company to raise money.
19 May 2020
How long can the good times roll?
Economy

How long can the good times roll?

Despite all the doom and gloom that has dominated our headlines for most of 2019, Britain and most of the rest of the developing world is currently en…
19 Dec 2019
Why Wall Street has got the US economy wrong again
Economy

Why Wall Street has got the US economy wrong again

The hiring slowdown does not signal recession for the US economy. Growth is just moving down a gear, says Brian Pellegrini.
25 Oct 2019
Central banks want politicians to take charge – but what will they do?
US Economy

Central banks want politicians to take charge – but what will they do?

The US Federal Reserve has come to the end of the road in terms of what it can do to accelerate any recovery, says John Stepek. It's over to the polit…
17 Sep 2020

Most Popular

Oil producers are back at their Covid-19 lows – is it time to buy?
Oil

Oil producers are back at their Covid-19 lows – is it time to buy?

With demand for oil hammered by Covid-19 and talk of “peak oil demand”, there are lots of good reasons to be bearish on oil producers. So, asks John S…
22 Sep 2020
Why you should stuff your end-of-pandemic portfolio with Chinese stocks
China stockmarkets

Why you should stuff your end-of-pandemic portfolio with Chinese stocks

For an end-of-pandemic portfolio, you need assets that can cope with today’s volatility. And that, says Merryn Somerset Webb, means Chinese stocks.
14 Sep 2020
IAG's share price is ready for take-off - here's how to play it
Trading

IAG's share price is ready for take-off - here's how to play it

The owner of British Airways has had a turbulent year, but is now worth a punt. Matthew Partridge explains the best way to play it.
8 Sep 2020