Saturday, 22 September 2018

Anywhere but Treasuries

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  • Jonathan Rogers
The Trump reflation trade could turn out to be positive for local currency Asian bond markets, says Jonathan Rogers

FOR BELIEVERS IN the “Trump reflation trade”, last week’s rate rise from the Federal Reserve slotted into the script nicely. Indeed, so did the official view from the Fed that it will have room for perhaps three rate increases next year, based on the “dot plots” of Fed committee members, faster than the perceived pace of tightening before Donald Trump’s election, and certainly of a greater magnitude in absolute rate terms than was the market consensus earlier this year.

What appears to be unfolding in front of our eyes is the revelation the US economy is moving close to full employment, that the Fed itself believes in the Trump reflation trade - or at least in the fiscal loosening part of it - and the dawning realisation the US is moving into a different point in its economic cycle from most of Asia’s economies.

Growth in Asia is slowing under the influence of China, where poor demographics, in the form of a declining working age population, together with an attempt to steer away from investment-dominated activity towards a service and consumption-driven economy have produced the lowest growth in 25 years. A reining in of the credit expansion that has been rampant since the global financial crisis has also knocked the economy back.

The implications for growth in the rest of Asia as the result of reduced trade with China would imply lower bond yields in local currency markets, barring capital flight in the face of declining currencies.

This has yet to manifest itself as the Fed embarks on its rate-tightening agenda and, certainly, there has been none of the level of panic in local bond markets which was seen in 2013 when the “taper tantrum” knocked debt prices amid fears of the withdrawal of quantitative easing.

Indeed it’s worth noting Asian bonds performed well during the last round of Fed tightening which kicked off in 2004, delivering an annualised 8% return in local currency terms. Local Asian currencies also weathered the two-year rate tightening which added 425bp to the Fed Funds rate, gaining on average 12% between 2004 and 2006.

WILL IT BE different this time? I suspect in currency terms it will be, at least for a while if the price action last week in the wake of the Fed tightening is anything to go by. Asian currencies were knocked against the dollar and that element of the action seems to be at the crux of the Trump reflation trade.

Since he won the presidency, Trump’s rhetoric appears to have been swallowed hook, line and sinker by financial markets. The US Treasury curve has backed up and US government bonds now yield a spread to German Bunds last seen in 1990.

That’s pretty spectacular price action, and there are calls from many quarters, not least from the distinguished Henry Kaufman, that the 30-year-odd rally in Treasury bonds is at an end. Goldman Sachs sits in the same camp: the bank’s analysts are recommending dumping Treasuries and buying gold to capture the Trump reflation trade.

It’s easy to see the thinking on the assumption Trump acts on his promise to slash US corporate tax rates, that he does indeed invoke an amnesty for the US$2.5trn or so of American corporate cash parked overseas and that he ramps up US infrastructure spending.

The latter plan alone implies a wave of increased supply in US government debt. And if that comes to pass, with the next debt ceiling negotiations due to take place in March, the supply element, to say nothing of the credit element, would imply an upwards trajectory for US Treasuries.

But his wild plan to double US GDP would suggest a weakening of the dollar to compensate for the reduction in tax revenues and to massage unit labour costs down in export terms. And that would be good news for the rates picture in Asia as the region’s governments attempt to retain currency competitiveness in the face of a dollar decline.

SO I BEGIN to wonder if a Trump reflation trade might not involve buying local Asian government bonds, where there is certainly still a lot of meat to be had in absolute yield terms. The dollar seems likely to continue in its current pomp for some time yet, so perhaps a currency hedge would be appropriate.

But in the longer run I find it hard to imagine that a weaker dollar will not be a cornerstone of Trumponomics and so, at some point, those hedges can be lifted while riding the yield compression which I believe will be coming to Asian bond markets.

For years now, global debt markets have been operating under the mantra of the quest for yield. That modus operandi hasn’t gone away just yet. But as it appears the US economic cycle is about to diverge definitively from that of Asia thanks to Trumponomics the new mantra might just be “anywhere but US Treasuries”.

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