How to play yields

Financial markets have greeted Donald Trump’s re-election with optimism. Risky assets, particularly equities, extended their strong rally in early November, despite rising inflation expectations and reduced hopes for Federal Reserve easing.

The S&P 500 has surged 28% year-to-date, with much of the gain fueled by tech stocks. Historically, U.S. equity markets have tended to perform better under Republican administrations than Democratic ones¹. Trump’s pro-business agenda, which includes tax cuts and infrastructure investments, aligns with this trend, giving investors reasons to remain upbeat.

Tariffs: A Double-Edged Sword for Markets

While growth-focused initiatives from the administration drive optimism, they also present challenges. Higher inflation and reduced monetary support may test market resilience, but for now, these hurdles appear manageable. The administration’s business-friendly stance continues to inspire investor confidence, laying a foundation for optimism even amid uncertainties.

However, financing these spending proposals comes with complexities. Tariffs—famously described by Trump as "the most beautiful word"—are proving highly disruptive. Targeting major trade partners like China, Mexico, Europe, and Canada, these measures strain markets globally. Beyond curbing growth potential, tariffs introduce inflationary pressures that are harder for markets to digest. Unlike growth-driven "good" inflation, this tariff-induced "bad" inflation poses a significant challenge for investors.

Government Bond Yields Nearing Their Peak

Rising interest rate and inflation expectations have created headwinds for bond investors, but there are signs that government bond yields may be approaching their peak.

First, from an economic growth perspective, the Federal Reserve has little reason to abandon its easing stance. Despite recent rate cuts, monetary policy remains restrictive. Real money (M1) growth is hovering near historical lows, and broader indicators like the U.S. Wave² point to rather weak economic growth, as shown in Figure 1. These conditions suggest the Fed remains committed to further easing.

Second, markets appear to have priced in an overly pessimistic scenario for bonds. Current U.S. 10-year yields are overshooting levels justified by historical drivers of yields, as shown in Figure 2. Looking ahead, inflation expectations—if Trump’s first term is any guide—may ease slightly. Post-election uncertainty often brings an initial spike in inflation expectations, but these tend to recede as the dust settles. Incorporating this information into our proprietary model results in a 10-year yield forecast well below the current level.

While challenges persist, these factors provide a constructive outlook for bond investors navigating the current landscape.

How We Prefer to Play a Constructive View on Duration

Timing the peak in government bond yields is challenging, especially with the uncertainty surrounding U.S. import tariffs. While a general 10% tariff and a 60% tariff on China could represent the upper limits, past history suggests that Donald Trump may use tariffs as a bargaining tool, potentially resulting in lower levels than currently proposed.

Given this uncertainty, we believe that taking an outright long-duration position is not the most effective strategy, even with our medium-term positive outlook. What’s sure though is that the reduced election-related uncertainty has helped lower government bond volatility, as shown in Figure 3. What happened in the post-election period was to be expected, as bond volatility historically eases in the months following election day, as Figure 3 depicts. In light of this, we prefer to express our positive view on duration through options. This approach allows us to capitalize on a potential decline in yields in 2025 while avoiding the risks associated with attempting to time the bond market.