In late 2024, significant political events in the United States and the United Kingdom disrupted previously stable bond markets. Donald Trump’s return to the US presidency and the UK Labour government’s inaugural budget defied economic forecasts, leading to increased bond yields. However, a closer examination suggests that the market’s apprehensions may be overstated, presenting potential investment opportunities.
After experiencing a period of calm following the bond bear market of 2022 and 2023, US Treasuries and UK Gilts were jolted in the autumn of last year by major political events on both sides of the Atlantic. Donald Trump’s presidential election victory and the United Kingdom’s new Labour government’s first spending budget upended economic and market expectations.
With the Republican party’s clean sweep of the election, winning control of the White House and both chambers in Congress, market participants anticipated a repeat of the fiscal stimulus and tariff measures from Trump’s first term.
It was feared that extended tax cuts would result in greater bond issuance and tariffs were seen as inflationary, a potent combination if realised. As a result, US bond yields rose aggressively and the yield curve steepened as the bond market priced in the prospect of what has been dubbed “‘Trump 2”.
Across the Atlantic, events in the UK compounded this dynamic. The Labour Party, fresh from a General Election victory, has traditionally been seen as fiscally imprudent. Determined to overturn this view, incoming Prime Minister, Keir Starmer assured markets by pledging to establish Labour as the party of “sound money.” The Gilt market took him at his word, seen in the smooth market transition from the previous Conservative Government to a Labour Government.
This entente was short-lived, however. With Labour’s inaugural budget, Chancellor Rachel Reeves shocked markets with a £40 billion tax increase—the largest since 1993 – coupled with substantial spending plans. In response, the Office for Budget Responsibility revised growth and inflation forecasts upward and the Debt Management Office announced increased debt issuance, spooking Gilt market investors and pushing yields higher.
Yet, despite these market jitters, I believe the market’s reaction has been overly pessimistic on a number of counts. Firstly, and most importantly, labeling the new US administration as ‘Trump 2’ overlooks the fiscal realities it faces. While President Trump will be keen to extend tax cuts, he cannot ignore the dangerous burden being placed on the US economy by debt servicing costs. In the year to end September 2024, the US Treasury spent $882 billion on net interest payments equivalent to 3.1% of GDP – the highest ratio since 1996 – and, notably, surpassing military spending for the first time.
Secondly, the inflationary impact of tariffs is far from clear-cut. While conventional wisdom suggests they push up prices by raising import costs, I see them as ultimately disinflationary—stifling growth and forcing prices down through ‘beggar thy neighbour’ effects. This is a complex area and a divisive issue among many esteemed economists and central bankers. As far as the UK is concerned, the Bank of England sees tariffs as unambiguously bad for growth, with an uncertain effect on inflation, though with a bias towards dampening price pressures.
Thirdly, this is all occurring against the backdrop of already deteriorating growth in major economies. The Chinese economy is growing at the weakest pace in decades and losing momentum, while Europe’s largest economy is entering recession. Tariffs threaten further deterioration in this dynamic.
Given the ambiguity on the potential impacts of tariffs and the need to keep bond yields capped because of the deteriorating debt costs, I feel that market concerns are overdone. The current elevated yield levels – last seen in the mid 2000s – against the backdrop of weakening Chinese activity, core Europe entering recession and major central banks cutting rates, look to me to be attractive in an historic context.
Taken together, these factors suggest that the market’s current pessimism may be unwarranted.
By Daniel Loughney, Head of Fixed Income, Mediolanum International Funds
