The Federal Reserve may be powerless against inflation! US bonds may face a "shock"

Investors remain nervous about the risk of rising inflation in the United States, these risks (such as the outcome of the U.S. presidential election on November 5) have not yet been reflected in the bond market - and Federal Reserve officials may be powerless to address this.

As of Tuesday, prediction markets showed Republican candidate Trump leading Democratic candidate Harris in the White House race. An earlier survey by The Wall Street Journal this month found that economists believe Trump's policies would bring higher inflation, interest rates, and federal deficits than Harris's policies. However, a separate survey by Bloomberg shows that regardless of who wins, the inflation outlook and economic growth will be roughly the same.

Despite developments in the Middle East leading to a drop of over 4% in crude oil futures and a decline in U.S. bond yields, concerns about inflation risks persist. As of last Friday, bond market volatility measured by the ICE BofAML MOVE index remained close to its highest level this year.

The emerging question now is whether the United States is entering a new phase in which inflation may exceed the control of the Federal Reserve, especially as the country shifts to a more closed trade policy and struggles to control its nearly $35.7 trillion national debt and approximately $1.9 trillion budget deficit.

Eric Vanraes, head of the fixed income department at Eric Sturdza Investments, stated that the U.S. debt burden is "unsustainable" and "continuously rising". The company manages $1.2 billion in assets as of May. Vanraes said, "Trump's potential victory, along with competition from more attractive bond strategies, is not a positive factor for long-term bonds."

In an email, Vanraes wrote, "It is expected that Trump's plans will put some pressure on long-term rates by slightly increasing inflation. However, if Trump wins the presidential election and the Democrats control Congress, his plans will not be fully realized. For the market, who controls both houses of Congress is as important as or even more important than who wins the presidential election in terms of long-term yields."

Rising inflation risks often manifest through triggering sell-offs in the bond market, lowering bond prices, and causing bond holders to miss out on surging yields, thereby hurting existing long-term bond and note holders. Such risks may also spill over into currency and stock markets.

Matt Rowe, head of portfolio management and cross-asset strategy at Nomura Asset Management, said, "Looking ahead, I believe higher inflation will be part of reality, in part because we have squeezed everything possible in efficiency driven by globalization and pushed up the prices of risk assets. If we accept the higher cost structure brought by the 'reshoring' of the supply chain and move towards a more closed economy, then the scope for interest rate policy is limited."

Rowe said, "Globalization, friendly trade policies, and loose policies have calmed down for nearly 15 years. Now, as we emerge from years of loose conditions, witnessing the contraction of globalization/reshoring and overall more closed policies, we are in a much more complex environment In addition to the escalating inflation concerns, people are paying more attention to the so-called "neutral" interest rate, which is a theoretical level of interest rate that neither stimulates nor restricts the economy. This neutral interest rate may be higher than generally expected, triggering concerns that excessive lowering of borrowing costs by the Federal Reserve could lead to another wave of inflation.

Anthony Saglimbene, Chief Market Startegist at Ameriprise Financial, stated that while short-term inflation pressures may ease, both Harris and Trump "have proposed potentially increasing the already tense debt and deficit situation, and fiscal policies that could increase inflation pressures. Therefore, the outcome of the U.S. election, including the composition of Congress after the election, may play a larger role than ever before in shaping the long-term inflation path and the national fiscal position."

Saglimbene believes that "investors are more confident in the short-term easing of inflation pressures, while also seeing more resistance to long-term inflation easing. This interaction between short-term and long-term inflation may be one of the reasons why, despite expectations of further rate cuts by the Federal Reserve, yields on 2-year and 10-year Treasury bonds have recently risen."