The Dynamics of the Trump Reflation Trade
In its simplest terms it means to sell bonds and buy equities (not just any equity, those whose prices are correlated to a rising interest rate). Let’s look at why this works in a rising interest rate environment – not that we are currently in one, but could be in one at some time in the future (an easy thing to say since interest rates are close to zero). When you buy a bond you hand over a lump of cash and in return you receive per month as a coupon. If your coupon rate is higher than the interest rate (i.e. if then you are happy because you are earning a higher return than if you had kept your money stashed away in your savings account. The problem is, the interest rate changes but your coupon rate does not! So, if the interest rates rise higher than your coupon rate you are losing money because now your savings account (supposedly risk-free) is now more profitable!
The other side of this trade is buying equities with prices correlated to a rising interest rate (traditionally financials). This works in a rising interest rate environment because as rates increase, those equities have profits linked to interest rate margins (think of a bank charging a mortgage rate higher than the savings rate – that bank will make a profit, hence it’s market price will increase). Not all equities perform well in a rising interest rate environment, so you have to pick the right ones (do some simple correlation analysis and back test at the very least!).
Going back to bonds. We have another factor at play: the yield curve. Unlike with equities, whose future price is uncertain, a bond’s future yield is known to a certain extent. This is because, unlike an equity, a bond’s price is a fair value price, in other words, a bond’s price is precisely what it is because if it wasn’t there would be an arbitrage opportunity somewhere (meaning a risk-free profit could be made). Because of this, one generally knows the future value of all the coupons the bond will pay assuming current market conditions prevail – but, of course, that almost never happens. The shape of the yield curve changes continuously, but hopefully never by too much (the volatility), allowing one to see future rates: if the yield curve parallel shifts (not slopes – that implies differences between short and long term rates) upward then we expect that interest rates will rise in the future (to keep things arbitrage-free and supply-and-demand in check); if the yield curve shifts downward then the opposite may happen.
This leads us to a property of a bond called its duration. Think of this: suppose you have a bond maturing in 30 years. This means you get back what you paid for it after 30 years of coupon payments. That’s a lot of payments; meaning that’s a lot of payments whose coupon rate is worse than the prevailing interest rate. Conversely, a short-date bond of 1 year (for the same price) has much larger and fewer coupons in order to make up the value of the bond in just one year. Since rates don’t change much, that is much less time to experience an interest rate rise that renders your coupon worse off. We say that long-dated bonds are more sensitive to interest rates and thus it will have a higher duration. The opposite is true for short-dated bonds.
Since the coupon rate of a bond is fixed, if interest rates go up, then the price of the bond must fall (a higher interest rate than the coupon rate means you are losing money to a savings investor – hence the market value of that bond is less – people are saving rather than buying bonds so supply and demand dictate that the bond price goes down). So if you knew the price of a bond was about to go down would you buy it or sell it? Sell it of course. And that’s the Trump Reflation Trade: sell bonds and buy inflation correlated equities.
The Trump Reflation Trade benefits not from real-life but from a possible future of a multitude of events collectively known as Trumponomics. Thus, the Trade only works if Trumponomics works and this means the following must play out:
- Increasing personal & corporate incomes (through Trump policies such as tax cuts, tax credits, and cash repatriation,
- Increased infrastructure spending, deregulation (goodbye Dodd-Frank) and the U.S. independence on energy, and
- Changes to U.S.-specific trade agreements, tariffs, military spending and immigration policies.
These were all keywords we were bombarded with when Trump surprisingly won the November 2016 election but why should we believe that any of them will come true? We don’t, but we can’t afford not to! The market must price in these new events. And if they’re priced in we must trade to them.
So What Next?
How long can the Trump Reflation Trade go on for? It’s been going solidly for 5 months now, the S&P500 has hit record highs, bond prices are at record lows (yields at record highs). If interest rates rising strongly, we could always see an equity market correction or a downturn, but this means that money in equities must flow to somewhere else where it is making money. Not bonds, the coupons won’t beat the rates. Property? As interest rates rise so too do mortgage repayment rates. This could lead to more defaults and a higher than usual number of sellers. If the sellers have to compete with each other for buyers this lowers the price for property; and to this extent investors looking to get out of equities could put their money in cheap property. Another possibility is commodities, but they have recently rebounded far too strongly to entertain the idea that they will continue rising and thus be a good place to stash cash.
What About Gold?
Gold is a well-known safe haven – a place to store cash during a crisis. More people buying gold means that there is less of it available (gold extraction from the Earth’s crust is surprisingly constant and slow) and therefore the price per ounce must increase. So why would anyone invest their money in gold in anticipation for the upcoming monetary tightening? Ah, but do rising interest rates necessarily represent a crisis? It does if you believe that rising interest rates will pop a property bubble, for example. In general, rising rates does not constitute a crisis, thus the price of gold should be fairly stable during the next year or so. However, it is hard to ignore historical events, particularly 1973 and 1974 when the S&P500 index dropped 40% but gold increased 150%.
J. B. Maverick – The Effect of Fed Fund Rate Hikes on Gold – 09/10/2015
Justin Spittler – Here’s What Happens to Gold When Interest Rates Go Up – 07/12/2015
Sunshine Profits – Real Interest Rates and Gold – ~2013