Treasury Market Sell-Off Overdone?

The sharp sell-off in the long end of the Treasury market since the election is attributed to fears of the inflationary implications of the expansionary fiscal policy and trade policies espoused by Trump.  There are reasons to think that these fears have been overdone.

1.  President-Elect Trump has been pulling back from extreme statements he made during the campaign.   Perhaps a better sense of reality, constraints or responsibility are behind this pull-back.   While most of these new positions so far have negligible direct, near-term implications for the economy or markets, the same factors behind them could restrain the more market-important size of tax cuts he is expected to propose.  In particular, the Republican concern about the size of the Federal deficit -- underscored by Yellen in her latest Congressional testimony -- could put a lid on the amount of tax cuts.

           a.  Balancing tax rate reductions by eliminating some tax deductions could have distribution problems.  The mortgage deduction, for example, is important to middle class taxpayers.  This deduction already is largely phased out for upper income people.

2.  It is difficult to see a significant pickup in inflation in the next 6 months or more as long as the dollar stays strong.  While the consensus view is that Trump's desire to restrain imports will lead to higher inflation, this effect could be mitigated by the consequent narrowing in the trade deficit lifting the dollar further.

           a.  The October Core PCE Deflator, due November 30, is likely to print a modest 0.1% m/m, keeping it at 1.7% y/y. 

            b.  This low inflation print probably will not stop the Fed from hiking by 25 BPs in December.  The Fed's forward guidance will be the important new information.  My guess is that it will retain the expectation of 2-3 hikes in 2017.  But, Yellen could temper it by saying that the path will be very gradual in her post-meeting news conference -- which could mean the next hike would be in the Spring or Summer.  This combination could temper longer-term inflation expectations in the Treasury market while leaving the stock market unscathed.  It might be the event that triggers a rally in the Treasury market.