Update Bonds: Who to follow?
The US central bank appears increasingly divided and controlled by President Donald Trump. It was no surprise that Stephen Miran, on leave from his job as the head of the White House Council of Economic Advisers and now appointed as a Fed governor, made a case for much lower interest rates after the latest Federal Reserve policy meeting.
Typically, central bankers would now be focused on inflation, which remains above the target level, and employment, which is solid. They would therefore not be in a hurry to lower rates. Miran, however, is focusing on the neutral long-term interest rate, arguing that it is set to fall substantially due to Trump’s policies on tariffs, immigration and taxes.
Many economists will likely have objections to most of Miran’s arguments. And whether Miran is right or not is relevant in the mid to long term, but less so in the short term. For now, bond investors must guess who retains the upper hand. Will it be Fed Chair Jerome Powell, representing the independent Fed members who will let inflation and employment data determine the rate path or will it be Miran, which would be a signal for Powell’s successor as well as a sign that the Fed is losing its independence. The answer will determine the most likely rate path over the next year.
Whether the Fed will really lose its independence is a hard call, but we think it’s clear that it will at least be pressured, as Trump will not likely stop pushing for lower rates in the US. Therefore, a further steepening of the US Treasury yield curve next year, with higher yields on long maturity bonds, seems likely to us. This would also put upward pressure on long bond yields in other regions, with many developed markets already dealing with steepening pressures of their own. For Europe, this comes at a time when European government bond supply is set to pick up, while Dutch pension funds are set to lower their allocations to long maturity bonds (traditionally a large buyer in this segment).
Our recommendation is to avoid long maturity bonds (more than ten years). This does not mean investors should avoid all bonds. The “belly” of the curve (bonds that mature in three to seven years) still offers decent carry. This part of the curve is less exposed to steepening, as it is offset by the support of central banks anchoring short-term rates at low levels.