It’s the Bond Market, not Biden, That’s Giving Trump the Willies.

David Paul
Jun 24, 2019 · 7 min read

As Democrats take to the debate stage, Donald Trump is preparing an onslaught of real-time tweeting to define whomever his adversary might turn out to be eighteen months from now. It used to be a matter of courtesy and decorum that political parties stood aside as their counterparts had their largely unfettered moments in the public eye. Democrats tended to remain out of the limelight during Republican debates and conventions, and vice versa.

That might have been the way things used to be; but, of course, it is no longer the way things are. It is inconceivable that Democrats will be able to enjoy two evenings of primetime coverage without Donald Trump doing his best to steal the headlines; to assert himself onto center stage. To allow them to do so would violate every fiber of his being. Perhaps he will tweet punchy new nicknames. Perhaps he will rail against their socialist ways. Or perhaps Trump will go ahead and bomb Iran, and blow them out of the media cycle altogether.

Trump’s real enemy, however — the one that is keeping him up at night — will not be at the debates this week. His real enemy is a tougher one to troll or malign, or to dismiss with sandbox antics or adolescent ridicule. The enemy that keeps him up at night is the bond market, or, more precisely, the yield curve. If there is a single factor that looms to dictate the outcome of the 2020 election, it is the economy; and, traditionally, the time-tested harbinger that economic adversity lies just around the corner is an inverted yield curve. Right now, Donald Trump is presiding over the perfect economic situation from which to seek reelection — unemployment continues to fall to previously unheard of levels and the stock market continues to reach new heights — but the bond market is predicting that it won’t last.

The yield curve is something many people have an understanding of, even if they have never heard the term. They know that a fifteen-year mortgage has a lower interest rate than a thirty-year mortgage. Or they know that the interest rate on a thirty-day bank certificate of deposit pays a lower interest rate than a one-year certificate of deposit. That is to say, many people who have never heard the term “yield curve” generally understand that in the world of finance, the longer the period of time, the higher the interest rate. That is the normal shape of the yield curve: it is upward sloping.

From time to time, however, the yield curve flattens and, at extreme moments, it inverts, as short-term interest rates rise to become higher than long-term rates. This can happen because short-term rates are pushed up by Federal Reserve Bank, as it seeks to manage economic growth and keep inflation under control; or it can happen because investors become “risk averse” and put more money into long-term treasuries, which pushes long-term rates down. Or, as illustrated in the first graph here, it can happen when both of those things happen simultaneously, as has been the case over the past year and a half, as the Fed has been pushing short-term rates up, and increasingly defensive investors have been pushing long-term rates down.

This graph here sums up why the recent inversion of the yield curve has grabbed attention in the media. This graph presents the “slope” of the Treasury yield curve, as calculated by the difference between the yield on the 30-day Treasury and the yield on the ten-year Treasury. When the number is higher, the slope of the yield curve is positive and steep, when the number dips below zero, the short-term rate is higher than the long-term rate, and the yield curve is inverted. As shown here, over the past forty years, each time the yield curve has inverted (highlighted by the periods circled in red) a recession (shaded in gray) followed shortly thereafter.

This is what is keeping Donald Trump up at night. None of the Democrats on stage this week scare him, but the inverted yield curve is giving him the willies. It is why he has been lashing out at Fed Chairman Jay Powell — someone 95% of Americans have never heard of — more than he has at anyone since Jeff Sessions. In Trump’s view, Powell created this mess by raising interest rates to begin with. It is the Fed’s actions that have distorted the slope of the yield curve and that now threaten to undermine both the economy and Trump’s reelection chances, and he is doing is best to force the Fed to reverse course.

It remains to be seen, however, if the current yield curve inversion is as meaningful as many presume it to be. The world of economic theory has been in turmoil since the 2008 financial collapse, as one economic truism after another has fallen to the wayside. For example, macroeconomic theory presumes that there is a direct trade-off between economic growth and inflation. This fundamental rule is encapsulated in something called the Phillips Curve — shown here — which plots the relationship between unemployment and inflation, and suggests that as unemployment declines, inflation must begin to rise. The relationship makes sense: as the unemployment rate declines and the labor market tightens, employers are forced to increase wages to attract and retain workers. This increased cost is passed on to consumers, pushing prices upward.

The experience of the past decade, however, has defied the Phillips Curve. As illustrated here, since the dark days of the Great Recession, when the Dow Jones Industrial Average bottomed out at 6,469.95 — marking a 54% decline from its pre-crisis peak — and unemployment reached 10%, the Dow has risen by 240% and the unemployment rate now sits solidly below the magical 4% level that economists have long viewed as constituting “full employment.” All the while, as illustrated by the green dotted line, even as the economy has gathered steam, and the Fed has flooded the global financial system with dollars, inflation has remained stubbornly in the range of 2%. For all intents and purposes, the Phillips Curve has ceased to matter.

The collapse of long-term interest rates over the past several months represents a similar economic quandary. For years now, critics of the Fed have warned that once the Fed started to reverse its zero interest rate and quantitative easing policies, long-term interest rates were sure to spike upwards; the term hyperinflation was bandied about. Should foreign governments — notably China — taper off their own purchases of Treasuries at the same time, the rise in interest rates would surely be exacerbated, as the federal government struggled to find buyers to fund its massive deficits. Toward the end of last year, the bond market was gripped with fear as this scenario seemed to be unfolding. As the Fed began to taper off its holdings of treasuries, and China cut back its bond purchases, the rate on the ten-year Treasury bond jumped by more than 1% to 3.25%. Yet in this instance as well, conventional economic wisdom has been turned on its head. Despite both China and the Fed continuing to reduce their holdings of Treasuries — and with federal deficits ballooning past $1 trillion — the bond market has rallied and the yield on the ten-year Treasury has dropped to 2.00%.

It may be that the yield curve no longer predicts the future, as many economic commentators are now suggesting. Things are different today, some argue, as they point to the death of the Phillips Curve and a ten-year Treasury bond yield heading back toward historically low levels; while others simply suggest that the sample size makes the historical track record meaningless. But Donald Trump has his own evidence in mind, as he continues to badger his Fed Chairman to do whatever he has to do to give the economy a push and make the yield curve upward sloping again. His gripping fear of the inversion of the yield curve recalls the 1993 comments by Bill Clinton’s political strategist James Carville. “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” Clinton had just toppled the incumbent President George H.W. Bush, in large measure because an economic recession had overshadowed Bush’s successful prosecution of the first Gulf War.

Donald Trump’s evidence is George H.W. Bush and Jimmy Carter. They are the only presidents in the modern era to lose their bid for a second term. Each were brought down by economic adversity. They were weak men with failed presidencies, as Trump sees it, and to become the third member of that club would be the ultimate humiliation and defeat.

Follow David Paul on Twitter @dpaul. He is working on a book, with a working title of “FedExit! To Save Our Democracy, It’s Time to Let Alabama Be Alabama and Set California Free.”

Artwork by Joe Dworetzky. Check out Joe’s political cartooning at www.jayduret.com. Follow him on Twitter @jayduret or Instagram at @joefaces.

David Paul

Written by

Financial advisor to city and state governments. Lifelong Red Sox fan (don't hold it against me).

Dialogue & Discourse

News and ideas worthy of discourse. Fundamentally informative and intelligently analytical.

David Paul

Written by

Financial advisor to city and state governments. Lifelong Red Sox fan (don't hold it against me).

Dialogue & Discourse

News and ideas worthy of discourse. Fundamentally informative and intelligently analytical.

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