President Trump's Foreign Policy: What Will It Mean For The $14 Trillion Treasury Market?

Dan Fuss was visiting with clients and contacts in Tokyo in November during the week of Donald Trump’s surprise election victory. On Wednesday afternoon, Nov. 9, in Tokyo, when the results became clear, one of Fuss’s contacts handed him a piece of paper with the outcome.

“He looked me right in the eye and said `I am so sorry,’” said Fuss, who manages the Loomis Sayles Bond Fund. “And that’s the only comment I heard over the next two-and-a-half days about the U.S. election. The subject just dropped off the schedule.”

With the initial reticence Fuss observed about discussing the ramifications of a Trump presidency, came a reluctance from overseas investors to buy U.S. government debt at its auctions. Foreign investors bought 11.8% of the $171 billion of notes and bonds sold by the Treasury in December, the smallest proportion in any month since the Treasury adopted its current offering schedule in 2009. Demand rebounded in January to 19%, but was still below the 23% level of the year-before period.

President Trump, unlike his predecessors, embraces his ability to roil markets with offhand comments. Trump’s willingness to joust with foreign leaders on Twitter, as well as policies which hint at isolationism and protectionism, suggest an approach to governing in which foreign ties won’t be handled with the same gentle approach that has been customary. Some observers of U.S. government debt, 43.2% of which is owned by non-U.S. investors, wonder whether Trump’s policies and demeanor will change the way the world looks at Treasuries.

Since November election, Trump has threatened to levy a “border tax” on Mexican imports, imposed a travel ban on seven majority-Muslim countries, suggested he would reconsider the long-standing “one China” policy of the U.S. and sent mixed signals about his commitment to NATO.

“The geopolitical environment is getting less friendly, and we’re aggravating it,” Fuss said. The commonality of interest that participants in the global economy benefit from through international trade and investment is facing a major challenge. “Will this be bad for the Treasury market? I don’t know,” he said. “My gut tells me it’s negative.”

Yet bad diplomacy alone isn’t likely to convince other countries to sell Treasuries, said Brad Setser, a senior fellow at the Council for Foreign Relations and former Treasury Department economist under Presidents Clinton and Obama.

While the 43.2% of Treasuries held overseas is the lowest year-end total since 2003, the decline was well underway before Trump’s election, having fallen steadily from 50% in April 2013.

That drop doesn’t reflect a changing view of the U.S. so much as it’s a demonstration of how countries adjust investments to meet domestic needs, Setser said. For example, most of the reduction in foreign Treasury holdings comes from China, which has been selling the debt to boost the value of its currency to stave off capital flight. Saudi Arabia has also pared holdings to address budget problems stemming from lower oil prices.

U.S. government debt also lacks competition from a sovereign bond market with comparable depth and liquidity. Treasury trading volumes typically reach $500 billion per day within the Fed’s network of 23 primary dealers, which includes Goldman Sachs, Wells Fargo and JPMorgan Chase.

“In the short-term, existing financial relationships will stay largely as they have been and are,” said Mohamed El-Erian, the chief economic adviser at German insurer Allianz, in an email response to questions.

That’s not an endorsement of the status quo, however. In Asia, concerns were already heightened by poor U.S. economic management leading up to the global financial crisis, El-Erian said. Those anxieties “relate to the overall stability, well-functioning and standing of the multilateral system – one that gives Europe and, particularly, the U.S. huge privileges in return for responsible economic management of the global setup.”

The CFR’s Setser sees “a cost to overly aggressive U.S. policy and unreliability.” It will come not in the financial markets, but in a diminished “willingness to accommodate U.S. policy desires,” he said.

Setser expects that Trump will run larger budget and trade deficits, which will encourage greater foreign sponsorship of U.S. government debt. That’s especially true, should low bond yields in Europe and Japan persist, fueling demand for Treasuries on a relative-value basis, he said.

The run-up in 10-year Treasury yields from 1.6% before the election to as much as 2.6% in December on expectations that increased government spending will lead to larger deficits and faster inflation suggests that the market is functioning much as it should.

Yet, as with the uncertainty Trump has promoted in his approach to foreign affairs, there’s also a lack of clarity in Trump’s economic plans, which has led yields to drift down to 2.32% on Feb. 24. He has promised a “phenomenal” package of tax reforms in which equity investors are placing high hopes. However, politically challenging plans to repeal the Affordable Care Act and the Dodd-Frank financial reforms make it unclear when he will be able to push the plans that markets expect to produce faster growth.

“Markets seem to be giving him more credit for putting forward credible proposals and being able to pass them” than is yet warranted, said Wan-Chong Kung, a bond manager at Nuveen.

(Forbes)