- Election headlines may drive sentiment and volatility in the near term, but the Fed remains the principal driver of fixed income.
- Unlike the market’s traditional view that a divided government is best, we believe in this cycle the most effective and coherent fiscal policy will likely come from a unified government.
- Credit markets may react negatively to a contested election. We view pullbacks during these early stages of the recovery as good opportunities to put cash to work and that would be our general approach to election noise.
U.S. fixed income markets have become a sleepy place in recent months. As Fed policy expectations—or perhaps the lack thereof—have taken root, Treasury market volatility indexes have plunged to record lows with Treasury yields remaining largely range-bound across the curve for months. U.S. investment-grade corporate bond yields haven’t budged much over that timeframe either, with index yields also trading in tight ranges, mired at near-record lows below two percent.
Treasury yields have been in decline for the better part of 40 years, but with spikes along the way. In recent memory, the three episodes that saw Treasury yields move significantly higher in short order were the 2013 “taper tantrum” when the benchmark 10-year Treasury jumped from 1.6 percent to 3.03 percent on removal of Fed bond-buying plans; the 2016 election when it moved from 1.8 percent to 2.6 percent on tax cut and deregulation expectations, and then the passage of tax reform in 2017 which last drove yields to 3.25 percent from under 2.5 percent.
Now with the 2020 election the next potential major catalyst that could awaken fixed income markets from their slumber, how should investors be thinking about the risks and opportunities within fixed income at this juncture?
Put simply, we don’t see a scenario around the 2020 U.S. election that is likely to cause similar market moves, whether up or down, as the Fed will remain the biggest influence on markets for some time. But the prospects for further fiscal stimulus and other proposed policies under various scenarios could add some directionality to yields and credit markets, while potentially introducing some volatility for investors to take advantage of.
What's the scenario?
Summary of potential election-related impacts on U.S. fixed income markets
|Sector||Democratic president, Democratic Senate, Democratic House of RepresentativesD/D/D||Democratic president, Republican Senate, Democratic House of RepresentativesD/R/D||Republican president, Republican Senate, Democratic House of RepresentativesR/R/D||Our thoughts|
|FOMC makeup||Neutral||Neutral||Negative||Precedents suggest few changes under Biden; recent nominations by Trump suggest loyalists put in place, Fed independence eroded|
|Fed policy path||Positive||Neutral||Negative||The Fed will remain at 0% for years, but fiscal impulse under a blue wave likely helps to pull forward the next rate hike cycle|
|Deficits||Positive||Neutral||Neutral||A unified government is the clearest path to greater deficits; congressional gridlock limits scope for further stimulus|
|GDP||Moderately positive||Neutral||Neutral||Greater fiscal impulse amid higher deficits under unified government adds a modest boost to the growth outlook|
|Treasury yields||Moderately positive||Moderately positive||Neutral||The biggest factor that will drive Treasury yields is the path of Fed policy rates, again dependent on fiscal support; fading trade war fears under D/R/D may also send yields modestly higher|
|*TIPS (inflation expectations)||Moderately positive||Neutral||Moderately positive||The Fed wants higher inflation to achieve its new 2% average inflation target, fiscal stimulus aids that; trade wars & tariffs under R/R/D may drive different types of inflationary pressures|
|Credit markets||Negative||Neutral||Neutral||Under D/D/D, higher corporate taxes may increase the attractiveness of the tax shield from debt, boosting debt issuance and leverage from already elevated levels|
Table showing expected impacts of three U.S. election outcome scenarios on various fixed income investment factors.
Note: D = Democratic control, R = Republican control; symbols indicate qualitative estimates of positive, neutral , ) and negative *TIPS is Treasury Inflation-Protected Securities.
Source - RBC Wealth Management
Risks and opportunities around the election
The table above attempts to summarize how we’re thinking about the various election scenarios and potential market impacts. While markets have historically, and debatably, preferred a divided government for its tendency to provide policy stability, we think the opposite may be true this time around with a unified government better able to deal with high unemployment and the long economic recovery ahead.
All that matters, and the buzzword of the moment, is fiscal stimulus. And we think the clearest path toward that is via a unified government. At the moment, the “blue wave” scenario, where the Democratic Party controls the legislative and executive branches, remains the most likely based on polling and market indicators. The Democratic platform has pledged massive new spending programs, and higher taxes to pay for them, but on net should be a positive for the trajectory of the economic recovery. And while the issue of higher taxes may cause some market indigestion, we tend to think the actual appetite to raise taxes in the early years of a Biden administration given a weak economy may actually be quite low. As a priority, we think it likely falls to years three or four.
Because Republicans didn’t actually publish a party platform at this year’s national convention, we don’t have much idea as to what the party’s priorities and objectives would be, though the GOP has largely voiced concern about debt levels and little need to do more in terms of fiscal support. The Tax Cuts and Jobs Act, scheduled to expire in 2025, could be extended—a modest net positive for the economic outlook. Tough issues around trade and tariffs will continue to weigh on economic activity and sentiment.
Finally, the issue of a contested election remains. As in the aftermath of the 2000 election, we would broadly expect Treasury yields to trend lower on risk-off sentiment. Risk assets, including investment-grade and high-yield corporate bonds could come under pressure in this scenario, but during the early stages of an economic recovery, we would generally view any market pullbacks as opportunities to put money to work.
The next administration will have scope to reshape the Fed
For all intents and purposes, the results of the election—no matter the outcome—will have little bearing on the near-term trajectory of Fed policy. But the longer-term ramifications could be quite significant. Fed Chair Jerome Powell’s term runs through early 2022, as do many of the terms of the seven-member Fed Board of Governors, where two seats remain vacant. While we don’t necessarily expect major impacts on U.S. fixed income markets in the near term, the longer-term ramifications of these appointments could be highly significant.
Under a Biden administration, and regardless of whether Republicans hold the Senate, we would expect few changes and for Powell to remain on as Fed chair—as both President Clinton and President Obama left in place Republican appointees, Alan Greenspan and Ben Bernanke, respectively. Beyond that, the desire for continuity amid what is likely to be an ongoing economic recovery will likely take precedence. That said, the Democratic focus on regulation could make the vice chair for supervision position, created under the 2010 Dodd-Frank act and currently held by Trump-appointee Randal Quarles, the most likely seat to be replaced.
Under a status quo scenario where Republicans hold the White House and the Senate, the outlook for the Fed is less clear. President Trump’s recent Fed board nominees—Stephen Moore, Herman Cain, and Judy Shelton—have been more of the loyalist variety than his earlier nominations that included technocrats such as Powell, Vice Chair Richard Clarida, and Quarles. Though recent nominees have all withdrawn or failed to find bipartisan support in the Senate, it’s likely a trend that would continue, and Senate opposition may fade during a second term. Most notably, Powell could be replaced as he has often been a target of the president’s attacks since his term began in 2018.
The impact is hard to quantify as the Fed is already expected to remain on easy street throughout the next term, whoever may preside over it, but President Trump has often called for negative rates, and should the Fed become more politicized then policy decisions could become more divorced from the economic outlook.
Deficits matter, just not really
Of course, already massive fiscal and monetary stimulus, amid calls for even more, will undoubtedly raise fears around growing debt burdens. The Congressional Budget Office now forecasts publicly held federal debt to approach 110 percent of GDP in the aftermath of the pandemic, though not shown, it would be the highest since World War II.
As federal debt has risen, household debt has declined
U.S. household debt, federal debt, and the Congressional Budget Office’s forecasts of future federal debt are shown as percentages of U.S. gross domestic product (GDP) from 2005 to 2029. U.S. economic recessions are indicated in 2008-2009 and from 2020 through early 2021. Household debt rose until the economic recession of 2008-2009, then declined steadily, but ticked up recently as the U.S. entered a recession. Federal debt began fairly steady, then rose rapidly during and after the 2008-2009 recession, exceeding household debt in 2017. In the future, federal debt is projected to rise sharply through 2021 and remain above 100% of GDP through 2029.
Source - RBC Wealth Management, Bloomberg, Congressional Budget Office
Another way to think about this issue, however, is that debt burdens have shifted from consumer balance sheets to the federal balance sheet. In the decade after the 2009 financial crisis, household debt obligations fell from 100 percent of GDP, to around 75 percent, largely driven by lower mortgage-related debt. Over the same period, publicly held federal debt rose from around 50 percent to about 80 percent.
While some may harbor reservations and fears about rising debt levels, that shift should be a net-positive in terms of systemic risks, in our view, as the federal government obviously has greater capacity and more avenues to address debt service than the U.S. consumer, not least of which is the ability to print its own money. And sure, citizens can too, but it’s rather illegal.
We continue to believe that deficits and overall levels of publicly held federal debt are not a material concern for investors over the near and intermediate term. In terms of Treasury yields, higher Treasury supply alone is not sufficient to send yields higher, based on historical correlations. Factors such as the path of Fed policy rates, growth, and inflation expectations matter to a much greater degree.
We expect the Fed to continue buying Treasuries at an $80 billion monthly pace, at least, while a weaker dollar has improved the currency-hedged attractiveness of U.S. debt yields, which should keep foreign demand robust, while money market funds will be another source of significant ongoing demand.
Turning now from the hypothetical to the demonstrable—what has the Fed actually done roughly six months into its historic efforts to prop up the economy and markets? Well, in some respects, not a whole lot. And in many respects, it should have been expected as monetary policy is mostly about jawboning:
“When I was at the Federal Reserve, I occasionally observed that monetary policy is 98 percent talk and only two percent action. The ability to shape market expectations of future policy through public statements is one of the most powerful tools the Fed has.” – Ben Bernanke
And this seemingly applies to the Fed’s various lending facilities established in conjunction with Treasury as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act. When announced, the numbers were eye-popping. Over $2 trillion across a handful of facilities, with the potential to increase to as much as $5 trillion if needed.
Across the board the actual uptake has been minimal, totaling roughly $200 billion. Absent another market meltdown, we suspect this will continue to be the case. Corporate bond buying has received the most headlines, but the Fed is barely present in corporate markets at the moment, buying just $20 million per day in a market with daily volumes over $20 billion. But the Fed’s facilities, as intended, acted as a backstop for markets allowing companies, municipalities, and others to issue debt as they normally would, limiting the actual need for the Fed’s help.
With little wear and tear, trillion-dollar Fed facilities remain in like-new condition
The various facilities implemented by the U.S. Federal Reserve (Fed) to deal with the economic effects of the COVID-19 pandemic are shown in a bar chart. The facilities are divided into three categories: Credit market facilities, which include municipal liquidity, corporate credit, money market mutual funds, and commercial paper funding; “Main Street” programs, which include paycheck protection and Main Street lending to smaller businesses; and term loans, which includes asset-backed lending. Only a small fraction of each facility has been used to date.
Note: Money market mutual fund and commercial paper funding facilities have no technical limits; utilization numbers include equity contributions from Treasury, actual lending may be lower.
Source - RBC Wealth Management, Bloomberg, Federal Reserve
On the topic of light utilization of the Fed facilities, Powell and Treasury Secretary Steven Mnuchin addressed this in recent congressional testimony, and both showed willingness to reallocate funds and/or modify facility terms, particularly the Main Street Lending Program, to best address the ongoing recovery, which could be the next course of action.
Fixed income strategy
When rates are historically low, the fear is that they can only go higher—and for decades this has likely caused some investors to pursue suboptimal fixed income portfolio strategies despite ever-lower rates. Reinvestment risk will be the biggest challenge with the Fed now expected to keep short-term rates at zero percent through at least 2023, and likely through 2025, in our view. Therefore, the name of the game will be locking in yield and coupons where possible.
We remain comfortable with taking on prudent additional risk within fixed income portfolios to supplement income amid Fed support, stronger liquidity profiles for many corporations due to elevated levels of recent new debt issuance, and a progressing U.S. economic recovery.
We recently shifted to a slightly negative outlook on U.S. investment-grade corporate bonds with yields under two percent. We remain positive on high-yield corporate bonds where index yields remain at 5.8 percent. We also remain positive on preferred shares. Though they’re somewhat exposed to stock market volatility, the lack of material interest rate risk for the foreseeable future with the Fed on hold may increase the attractiveness of the sector.
The 2020 U.S. election is likely to prove to be one of the more contentious events in recent history. While the broad impact on fixed income markets may ultimately be relatively muted given the ongoing influence of Fed policy and market backstops, it could open up opportunities in a low-yield world for fixed income investors with a game plan.