Reading the Bond Market and Investing Through the Election

In general people overestimate the impact of politics on markets. Political regime changes usually have small effects on the general economy, and whatever effect it does have is felt slowly over time. Historically it has been rare that markets have moved as a result of new polls on political races. However, this year has been an exception. Over the last couple weeks the bond market in particular has reacted up or down depending on how large Vice President Joe Biden's lead appears to be. Here are my thoughts on why that is and what it means for investing through next week's election. Approach to Politics Generally speaking, I find binary events very difficult to invest around. Doubly so, I find non-economic binary events extremely difficult to handle profitably. I prefer to build trades where I have a number of ways I can win, whereas the binary event either happens or it doesn't. Moreover, I feel I have some level of expertise in analyzing economic conditions. I very rarely feel like I have a differentiated view on non-economic events. Elections are a perfect example of this kind of non-economic, binary event. Hence my approach starts with admitting that I don't know anything that the whole market doesn't know in regards to the election itself. Second, it is crucial to take your own political point of view out of it. It is extremely tempting to believe that if your candidate doesn't win there will be immediate and significant deleterious effects. You can't invest with this kind of emotion. I personally feel very strongly about this election, but I'm not expecting markets to validate my own feelings as a citizen. The market doesn't have an ideology. You have to approach markets completely coldly and objectively. Third, what either candidate will actually get done once elected is hard to predict. When President Donald Trump ran in 2016, he lambasted then Fed Chair Janet Yellen for keeping rates too low. Once elected, he pressured the Fed to do the opposite. He promised big infrastructure spending that never happened. He talked constantly about a wall that didn't get built. Making trades based on a candidate's projected policy moves is risky. Bonds Reacting More to the Senate Than to the Presidential Race Most of the media's attention is, understandably, on the presidential race. However, that isn't what has been moving the bond market in recent weeks. Biden's lead in the polls has been fairly steady, such that polls showing his lead slightly larger or slightly smaller probably don't move the needle much in terms of his odds of winning. Still, there's a big difference in Biden's ability to pass legislation depending on how many seats the Democrats have in the Senate. To be clear, I don't think a Biden win is a forgone conclusion, but I do think we can all agree it is a very likely outcome. The Senate is much less certain. Anything from the GOP remaining in the majority to the Democrats getting 54 seats all have reasonable odds. In particular, the bond market is laser focused on the possibility of a large Covid stimulus bill and/or infrastructure spending being passed early in the Biden administration. Whatever you think of the rest of the Biden platform, the markets definitely want more fiscal spending. Markets are also assuming that a Democratic majority in the Senate makes such a thing more likely. In addition, the larger the blue majority is, it increases not only the chance of some kind of spending package, but also the size of it. As such, we're seeing interest rates rise when it seems like Biden has a bigger lead, because that makes a Democratic Senate more likely, which in turn makes a large fiscal stimulus package more likely. Again this highlights how tricky trading politics can be. Six months ago, you probably wouldn't have guessed that Wall Street would be rooting for a blue wave, but here we are. Again, the market doesn't have an ideology. Looking Through the Election As I said, I really don't like trying to invest based on binary events, but I'm a long investor professionally. I can't just bury my head and pretend the election isn't happening. In that case I usually think about how I'd want to position if there wasn't an election coming, then test if anything about the election would upset that thesis. As I've been writing, my core thesis is that the economy is gaining momentum, and that momentum should probably cause longer-term interest rates to rise by some degree. It may be that a wider Biden win causes rates to rise more rapidly (or to a larger degree) than my original thesis, but it won't hurt my position. On the other hand, a Trump win or a more narrow Biden win may cause some of the Biden fiscal thrust to get priced out. That could cause rates to fall a bit. Maybe the 10-year Treasury falls from the mid-70 basis points area now into the 60's. But I'd argue that would only be temporary. In other words, I wouldn't have a different thesis, it may just take longer to play out. Focus More on the Impact on Inflation, Less on Treasury Supply One last thought. There are two reasons why you might think that the Biden spending plan will cause rates to rise. One is that the fiscal stimulus will increase aggregate demand, which in turn should improve growth and possibly create some inflation pressure. The other is that a larger deficit means more Treasury supply, which should push yields higher. My recommendation is to focus on the former and ignore the later. I admit that supply of Treasury bonds must matter in some theoretical sense. Economics 101 tells us that more supply must mean lower prices (and in this case higher yields), all else being equal. The problem is that the all else being equal is never actually the case. Indeed, as best, I can tell from the data, the all else seems to dominate the supply effect, so much so that I don't bother thinking about supply when making investment decisions. Here's a simple chart showing annual percentage change in Treasuries (excluding T-Bills) outstanding vs. the change in the 10-year Treasury. The R-squared of 0.03 tells you there's almost no relationship between the two. Source: SIFMA, Bloomberg This observation doesn't make a big difference to how I'm positioned now, but will change how I react to incoming news. If Biden were to win and first propose some Covid relief plan that involves sending checks directly to consumers, that has a very immediate impact on spending in the real economy. On the other hand, if he passes a large infrastructure plan that will take years before the money is spent, that has a totally different effect. That doesn't make one or the other better policy, but it will change how we should think about the impact on rates.

Reading the Bond Market and Investing Through the Election

Most of the media's attention is on the presidential race. However, that isn't what has been moving the bond market in recent weeks.

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