US bond sell-off: A harbinger of things to come?

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US benchmark bonds surged to four-month highs, with the 10-year US Treasury reaching 4.4% - almost one percentage point higher than in September - on the news that Trump had won the elections.

Though bond yields have somewhat settled this week, investors are still drawing parallels with the UK’s 2022 gilt crisis when significant bond-market turbulence forced British Prime Minister Liz Truss to resign, ending her brief 49-day tenure. Bonds also went into a tailspin when Trump won the 2016 election.

But how likely is it that the US will face a 'Liz Truss moment’ at some point when so-called bond vigilantes start calling the shots on government policy? The current situation differs markedly from what happened in the UK gilt market, and today's economic environment fundamentally differs from Trump’s 2016 election.

While the 2016 economy emerged from a tepid recovery, today's economy is cooling down from a period of overheating, making markets particularly sensitive to any hints of stimulus.

So it's incorrect to assume we should expect similar market reactions this time, says Levantine & co-managing partner Attila Kadikoy. He believes investors should rather pay careful attention to the Trump administration’s policy implementation, spending patterns and economic developments in the months ahead.

The costs of fiscal expansion are real and significant. If followed through on, the policy-promises Trump made during his campaign could substantially increase the government’s debt burden.

Proposed high net-worth individual and corporate tax cuts would reduce tax revenues needed to finance what is now a 6% government deficit to GDP ratio by $7.5tn. Trump argues that tariffs will fill the gap, but the Tax Foundation, a US think tank, says that tariff revenues would fall well short of what is needed.

According to the Congressional Budget Office, projections show that federal debt-to-GDP ratios are climbing from 99% currently to 116% within a decade, eventually reaching 166% over a 30-year horizon.

This trajectory is primarily driven by demographic pressures and mounting interest payments. By 2054, interest payments alone could consume more than 6% of GDP, exceeding spending on Social Security.

The implications of sustained fiscal expansion extend beyond mere debt-service costs, with key concerns including:

• Reduced budgetary flexibility to respond to future crises or economic downturns
• Diminished national savings and increased reliance on foreign borrowing
• Potential "crowding out" effects on private investment

With these concerns hanging over the bond market, it’s little wonder the bond market sold off so sharply last week. Where do investors go from here? In the near term, Kadikoy points to several immediate market considerations.

"The Fed is expected to cut rates by 25 basis points at the next meeting, but the real question is how the broader fixed-income market will respond," he says. "Will the 10-year Treasury yield automatically adjust downward? These are critical considerations for investors."

Bond yields could face near-term upward pressure but may soon encounter resistance levels. The 10-year yield would only likely rise significantly above the federal-funds rate if markets begin pricing in potential rate hikes.

Kadikoy identifies several potential scenarios that could affect bond market dynamics. "Trade tensions and tariff policies could have a major impact on inflation," he notes.

"These factors, combined with the overall economic trajectory, will be crucial in determining market direction, particularly if the economy is weak by the time Trump is sworn in." He says the policy response could be quite significant because the Trump administration’s primary playbook is based on a growing economy.

Several key indicators are important to monitor, according to Kadikoy. These include:

• The response of real rates to potential Fed policy shifts
• The Trump administration's reaction to any economic slowdown
• The impact of potential trade policies on inflation
• The interaction between fiscal and monetary policy

While the bond market may not be at an immediate crisis point, the many unknowns heighten uncertainty and typically encourage market volatility.

However, the longer-term bond market response will largely depend on the specific policies Trump implements and their timing. Thus, investors should remain vigilant and adaptable as the situation evolves.