December 7, 2016 at 5:00 am ET
Donald Trump wasn’t supposed to win the election and the market wasn’t supposed to respond to a Trump shock with applause. But both have happened in the last month. Instead of a flight to safety, investors have moved away from Treasurys and into riskier assets. Credit spreads have tightened. Why?
For the first time since the financial crisis there is broad-based optimism about the economy. Not just about a single sector or a single class of assets, but about the U.S. economy as a whole. It’s based on expectations that the new administration, working with majorities in Congress, will end Obama-era policies that have channeled investment away from risk-taking and into safe spaces.
Since the 2008 election and the heart of the financial crisis, weekly 10-year Treasury yields have averaged 3 percent, far below their pre-crisis average of 7 percent going back to 1962. In July, the yield hit an all-time low of 1.4 percent. But since Trump’s victory, yields have jumped 40 basis points and are at a one-year high around 2.4 percent. The urgent need to be in government bonds has dissipated.
But the story is not that investors don’t want to be in bonds anymore – corporate credit spreads have tightened at the same time. It’s the reverse of what happened during the financial crisis when Treasurys rallied and credit spreads widened. Investors have begun to take their money off the sidelines and put it back into the real economy, starting with corporate bonds.
The curtain call on the era of “the first sub-zero interest rates in 5,000 years,” as James Grant describes it, is no small feat. Inflation, though also low, effectively forced savers to pay the government to borrow their money. This financial repression has cost savers around $470 billion (according to one study by Swiss Re), spawned a public pension funding crisis, shrunk endowed research funding and helped consolidate the banking system by forcing down net interest margins.
But those were only the residual effects. The brunt of the damage to the economy has come in the form of a credit crunch for small, unrated borrowers. Cut off from the capital markets, Silicon Valley and the traditional banking system, these high-potential contributors to the economy are in most need of investment and have had little to work with the last eight years. As one small business owner in Georgia recently told the Wall Street Journal, “You can’t get credit until you can demonstrate you don’t need it.”
As a result, economic growth has been anemic, labor productivity growth has plummeted and high-quality job growth has stalled out. A new study coauthored by President Barack Obama’s former Chairman of the Council of Economic Advisers Alan Krueger found that 94 percent of the jobs created between 2005 and 2015 were in temporary, contract or freelance capacities. This came on the heels of a loss of about 25 percent of the nation’s manufacturing jobs — mostly well-paid, nine-to-five positions — following China’s entry into the World Trade Organization in 2000.
A renewal of credit access to revitalize the economy can be completed only if the Federal Reserve acts in concert with the rest of Trump’s reversal of the Obama agenda and unwinds its quantitative easing program. Since 2008, the Fed has temporarily tripled its balance sheet by purchasing $3 trillion in Treasurys and mortgage-backed securities as a crisis-fighting strategy. Investors have stood pat and waited for the central bank to sell them back these super-safe assets. The opportunity cost of this program is that their money doesn’t get lent to startups and small business. Until that happens, the credit crunch will drag on.
Fed Chair Janet Yellen has said she will stay until her term ends in early 2018, making it unlikely that this unwinding will happen in Trump’s first year in office. But the bond market – to the Fed what the white working class vote was to Trump – has already started to bid her goodbye. Investors can see compelling reasons to lend their money at the high-growth margins of the private sector rather than to the government.
Rich Danker is principal of Kiowa Strategies, where he consults on markets and public policy.
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