"Trump Trade" restarts "steep curve trend" bet, but success depends on the Federal Reserve

Political factors have injected new vitality into one of the most troubling bets for bond traders, but only the Federal Reserve can truly provide assistance. The momentum of Donald Trump's presidential campaign has pushed up long-term US Treasury yields, putting pressure on them. The market believes that the tax cuts and tariff increase plans of this Republican presidential candidate will trigger inflation and worsen the US fiscal situation - if the Republican Party controls the US Congress with overwhelming advantage, the situation will be even more serious.

The side effect of this "Trump trade" is that investors who bet on the bond market returning to normal from the unusual period of inverted bond yields have been rewarded. However, for this trade to truly gain a foothold, the Federal Reserve needs to achieve the next target by lowering the target interest rate. This should lay the foundation for the continued decline in yields at the shorter end of the yield curve.

John Madziyire, Senior Portfolio Manager at Vanguard, said: "Fed rate cuts are an important catalyst for steepening the curve. Politically, the possibility of an overwhelming victory in the November election means that the fiscal deficit will become a top issue."

Over the past two years, the bond market has been in what is known as a yield curve inversion, with the 2-year US Treasury yield exceeding the benchmark 10-year US Treasury yield. Many have bet that the yield curve will return to normal, but in most cases, it has been in vain. However, this situation is changing.

On Monday, following the shooting of Trump over the weekend, the 30-year US Treasury yield exceeded the two-year Treasury yield for the first time since January 31, as investors weigh how the resurgence of Republican voters following the weekend may affect the results of the US House and Senate elections, as well as the Republican National Convention starting on Monday.

Victoria Fernandez, Chief Market Strategist at Crossmark Global Investments, said on Monday: "We need to take a step back because there is still a long time until the election, and things could change quickly." She added that if the yield curve "steepening" triggered by Trump continues, it will have "a lot to do with what we see at the convention results" and whether Trump's campaign can attract moderate voters.

The Federal Reserve will be the biggest driver of the steepening yield curve

With this dynamic unfolding, investors are turning their attention to how aggressively the Federal Reserve may cut rates this year, which is another key factor for US Treasury yields to return to a normal environment. The so-called steep curve is usually driven by expectations of an imminent rate cut by the Federal Reserve, and until recently, the Fed has been hinting at keeping rates high for longer. This has limited the room for a significant rate cut After a year of the Federal Reserve raising borrowing costs to a high level of 5.5%, the outlook seems to have improved. Inflation appears to be finally cooling down, and the market generally expects further progress in this area to prompt the Fed to ease rates before September. Overall, traders expect a 1.5 percentage point rate cut over the next 12 months.

Federal Reserve Chairman Powell stated in a speech on Monday that the U.S. has made progress on inflation, but he refused to indicate any policy shift by the Fed in the future, reiterating that a "surprisingly" weak labor market would trigger rate cuts.

Traders will focus on Tuesday's retail data and the impact of retail data on consumer health and the Fed's policy path. So far, the market has fully priced in the expectation of a 25 basis point rate cut in September, with the likelihood of a third rate cut in December at around 60%. Goldman Sachs economists stated on Monday that they even "see solid reasons for Fed policymakers to cut rates at this month's meeting."

Although the 2-year U.S. Treasury yield remains higher than the 10-year U.S. Treasury yield, the spread between the two has narrowed from 51 basis points at the end of June to 23 basis points.

Vineer Bhansali, founder of LongTail Alpha, a California-based asset management firm, has maintained positions betting on a steepening yield curve and has reduced trading costs through derivative structures. Bhansali stated that economic data and the Fed's outlook are also key factors in Trump's victory. He said, "I think Powell really wants to cut rates now. This is what is driving the decline in short-term yields. As for long-term yields, the market seems to think that almost no one has a chance to compete with Trump now."

Costs for betting on a steepening yield curve remain high

Trading prices for steeper U.S. Treasury yield curves are expensive, and the cost of providing funds for this position may leave traders empty-handed, so this bet has often been stagnant in recent months. Steven Englander, a strategist at Standard Chartered Bank in New York, said, "This is the problem with U.S. Treasury trading at the moment. Given the losses investors have suffered in shorting bonds, they may want to ensure that Trump's trades dominate before shorting fixed income bonds again."

Bhansali is not deterred. He said, "The steepness hasn't been great for a while, but it's been very good this month. Once the yield curve moves, it really moves." He expects that from now on, the spread between the 2-year U.S. Treasury bond and the 30-year U.S. Treasury bond will decisively turn positive and eventually expand by up to 2 percentage points For others, the normalization of the US Treasury yield curve has little to do with Trump, which means the biggest move may not have arrived yet. Tim Graf, Head of Macro Strategy for EMEA at State Street Global Advisors, said: "I tend to think this is more about slowing inflation and a slowing labor market, and the Fed playing a bigger role, rather than Trump. I think everyone thought Trump's election as president would lead to inflation, but it's not that obvious."