Much has happened in the past week in the run-up to the US elections with strong implications for the US rates market. Some managers, like Nick Maroutsos from Janus Henderson, are positioned for a back-up in long-end rates on the back of a democratic sweep. Others are not quite so sure with what happened in the 2016 elections. One thing is certain in the aftermath of the Nov 3rd decision and that is the US bond market will experience a period of increased volatility as we close off 2020. Use Overbond’s liquidity scoring and bond screening to navigate the turbulent market.
Amid all of the investor focus on a potential messy political battle over the results of the U.S. presidential election, there is one scenario that could shake up the bond market the most: A clear and undisputed winner.
This is likely one of the most-underappreciated risks of the Nov. 3 vote, with the potential to push the 10-year Treasury yield back to 1% in the weeks that follow, a level it hasn’t touched since the first quarter. While it may not be the base case for many prominent investors, some are positioning for it just in case.
Nick Maroutsos of Janus Henderson Investors is building a “war chest of cash,” among other things, in part to react to opportunities from any volatility the election produces through year-end. Goldman Sachs Group Inc. strategists say a scenario in which Democrats take the White House and both chambers of Congress — what’s known as a “blue sweep” — “would imply the most upside to yields.”
“A strong, broad, blue victory, one that empowers the more progressive caucus in the House, is the only scenario I see in which long-end rates would spike by a lot after the election,” said Gregory Staples, head of fixed income at DWS, which oversees about $800 billion globally. “A mandate to significantly stimulate fiscally would possibly scare bond vigilantes, steepening the yield curve. I don’t view this as likely. But we are confronted with multiple scenarios, of which this is one.”
The risk that yields pop higher is deemed so unlikely that traders of eurodollar options are more focused on a possible year-end funding squeeze than the U.S. election. Strategies that typically might be used to hedge event risk are finding little demand and volatility remains near historically low levels. Even cheap, speculative bets on more turbulence aren’t finding a bid, despite the possible payoffs, according to traders.
Nonetheless, the notion of an unassailable victory by Joe Biden is beginning to take hold: A sweep by the Democratic Party that causes a bear steepening of the Treasury yield curve, in which long-end rates rise faster than short end, is quickly becoming a consensus trade.
Maroutsos, who is head of global bonds at Janus, actually sees a greater likelihood of an election outcome marred by lawsuits, claims of voter fraud, and overall angst that produces short-term swings in both directions for 10- and 30-year Treasury rates. Still, he’s positioning now for a potentially bigger, though contained, upward spike in long-end rates if his non-base-case scenario of a clean election result comes to fruition.
Long Rates ‘Vulnerable’
“With rates approaching all-time lows and the Federal Reserve on hold indefinitely, there is risk that the back end could be vulnerable due to a positive-type shock,” he said, without predicting whether Biden will win or Donald Trump will be re-elected.
He figures such a development could push the 10-year yield to as high as 1% by year-end or early 2021, from a current level of 0.65%, and the 30-year rate to just under 2% from 1.42% now. The 10- and 30-year rates haven’t been at those levels since March and February, respectively.
Maroutsos isn’t alone in his views. Goldman strategists Praveen Korapaty and Avisha Thakkar also see the potential for the 10-year note’s yield to rise by 30 to 40 basis points by early December on expectations of increased government spending, if Democrats take the White House along with control of the House and Senate.
Yet these types of views are far from universal. Standard Chartered Bank’s head of research, Eric Robertsen, believes the opposite could happen: He says a victory by Biden, plus full Democratic control of Congress, would produce concerns about their tax agenda that weigh on risky assets and drive Treasury yields lower on safe-haven flows.
Ultimately it will be the policy mix from the next president and Congress, rather than possible delayed election results, that has an impact on financial markets, according to Mark Heppenstall, chief investment officer of Penn Mutual Asset Management, which manages $29 billion of mostly fixed income.
“A sweep by either side could lead to an increase in long-end rates, which are more susceptible to greater fiscal stimulus and a lack of gridlock, similar to what occurred after Trump’s victory in 2016,” said Heppenstall.
For now, many investors are focused on the prospect of a messy election fight that produces market turbulence — especially among riskier assets. President Trump has repeatedly railed against the expected surge in mail-in voting amid the Covid-19 pandemic, alleging it will produce unprecedented voter fraud.
With Treasury yields lingering near record lows and the Fed vowing to pin its interest rate near zero until at least 2023, volatility in rates could remain subdued even if it surges in the stock market. Traders of swaptions, the options market on interest rate swaps, remained unperturbed even after Trump refused last week to commit to a peaceful transfer of power if defeated — with volatility drifting lower after a brief spike in the three-month tenor that captures Election Day.
‘The Whole Royal Family’
Maroutsos isn’t taking any chances. He’s buying shorter-duration debt from the U.S., Australia and Canada, where he thinks central banks are on hold with rates and the bar for hiking is “out of reach.” Janus may also look into buying puts on 10- and 30-year Treasuries in the next month or so, as a form of cheap protection from a positive shock that produces higher long-end rates, he says. The firm currently has no exposure to 30-year Treasuries and a “mild steepener in play” in the 10-year, he said.
Meanwhile, Maroutsos says he is keeping cash reserves high at around 20%-30% in absolute terms for a variety of reasons, one of which is to “keep powder dry should good investment opportunities present themselves.” Janus manages a total of $350.4 billion in assets, $13 billion of which is in Absolute Return strategies Maroutsos helps oversee.