By Karen Brettell and Richard Leong
NEW YORK (Reuters) - Bond traders are preparing for higher inflation after Republican Donald Trump’s surprise victory in Tuesday's presidential election, betting that trade protectionism and a falling dollar will boost the cost of oil and consumer goods alike.
Any jump in inflation could have wide-reaching effects on the economy, which investors and economists are only starting to grapple with.
At the same time higher fiscal spending and tax cuts may lead to even more debt supply, which would be a further drag on bond valuations, while any discussion of debt renegotiations could be a catalyst for widespread selling.
“The anticipated policy changes from the new administration will be a decided shift and have ramifications for the shape and level of the yield curve,” said Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets in New York.
Long-dated U.S. Treasury yields soared to their highest levels in 10 months on Wednesday and the yield curve was the steepest since February as investors adapted to the election result. Higher inflation erodes the value of bonds, with long-dated debt most vulnerable to price rises.
The breakeven rates on Treasury Inflation Protected Securities and inflation derivatives, which measure investors' inflation expectations, jumped to levels not seen since July 2015, according to Reuters data. <USIL5YF5Y=R> <USBEI5Y=RR> <USBEI10Y=RR>
Shares of financial stocks rallied, with the S&P 500 Financials sector jumping 4.1 percent in afternoon trade Wednesday, a gain nearly four times that of the broader index, on expectations that higher interest rates will boost bank profits and encourage more lending. JP Morgan Chase <JPM.N> and Bank of America <BAC.N>, the two largest banks in the United States, each rallied by more than 5.6 percent.
“More spending and more inflation is only going to help financial stocks,” said David Ellison, a portfolio manager at Hennessy Funds in Boston.
Protectionist policies, if adopted, are viewed as likely to hurt the value of the U.S. dollar, which could increase the cost of commodities including oil, which are priced in the currency. Stricter trade with China would also increase the cost of goods across the economy.
A key question for bond investors is whether the cost of higher prices on consumers as inflation rises would be offset by tax cuts and fiscal spending, or whether it could weigh negatively on economic growth.
“The type of inflation that comes from protectionism is effectively a tax on the U.S. consumer,” said Keith Price, managing partner at KPW Partners, an inflation and interest rate advisory firm, in London.
Goldman Sachs economists on Wednesday estimated that looser fiscal policies under Trump may add around 0.75 percent to annual gross domestic product, but added that protectionism is a concern for the economy’s longer-term growth potential.
Trump has indicated he would spend more on developing U.S. infrastructure, and with tax cuts also on the agenda that spending could come with higher debt levels that would be an additional drag on bonds.
“It would mean more spending and therefore greater deficits and maybe more supply,” Lou Brien, a market strategist at DRW Trading in Chicago.
An even greater risk to bonds may be the possibility that Trump will seek to renegotiate debt terms with creditors including China, or even default on the bonds, a prospect that came under scrutiny in May after Trump said on CNBC that “I would borrow, knowing that if the economy crashed, you could make a deal.”
“If that’s a realistic scenario then the ramifications are massive,” said KPW’s Price.
(Additional reporting by David Randall; Editing by Grant McCool and Andrea Ricci)