The Election Dynamics Between Trump and Harris Will Change the Outlook for U.S. Treasuries. Here's How

U.S. Treasury yields saw their largest weekly increase in weeks, with the 10-year U.S. Treasury yield rising to 4.2% as the market adjusted its expectations for Federal Reserve rate cuts and assessed the possibility of a soft landing for the U.S. economy.

In an interview last Wednesday, Stanley Druckenmiller, a former colleague of George Soros and now Chairman and CEO of a family office, stated that the market needs to lower its expectations for the speed and extent of Fed easing and revealed that he shorted Treasuries to hedge his positions when the Fed announced a 50-basis point rate cut in September.

In addition, the crypto-based Polymarket* and RealClearPolitics's data shows that the market is betting on increased odds of Trump winning the election. Concerns about the uncertainty of Trump's policies have also led to fluctuations in the U.S. Treasury market.

The combination of a "Trump victory" and an "economic soft landing" could impact the U.S. bond market, potentially welcoming a resurgence of inflation. ETF option implied volatility indicates that the market expects greater fluctuations in Treasury prices.

▶ Data supporting "slow rate cuts" comes as Fed officials adopt a hawkish tone

Last Friday, the U.S. retail sales data for September followed unexpectedly high CPI and non-farm payroll reports, again exceeding expectations and displaying strong economic momentum, further reinforcing the view that the economy is far from recession. Besides, concerns about the return of inflation pressuring the bond market also reignited.

Ahead of the November FOMC meeting quiet period, several Fed officials made statements on Monday. Lorie Logan, President of the Dallas Fed, stated that officials should act cautiously in the face of high economic uncertainty, and she supports "gradual" rate cuts.

Jeffrey Schmid, President of the Kansas City Fed, expressed his hope for a more normalized policy cycle, allowing the Fed to make moderate adjustments to sustain economic growth, price stability, and full employment. Slowing the pace of rate cuts could also help the Fed find a so-called neutral level—where policy neither pressures nor stimulates the economy.

Neel Kashkari, President of the Minneapolis Fed, supported the Fed's significant rate cut last month but reiterated his support for slower rate cuts over the coming quarters. He expected some more moderate cuts in the coming quarters to bring rates to a neutral level, although this will depend on the data.

After Monday, U.S. bond yields rose sharply, with the market further lowering its predictions for the extent of Fed rate cuts this year: a 11% probability of no cut in November, and an increased probability of just a 25 basis point cut by year-end.

Arif Husain, Chief Investment Officer of Fixed Income at T. Rowe, pointed out that the 10-year U.S. Treasury yield will test the 5% threshold in the next six months, steepening the yield curve, with the fastest path to this threshold occurring under minor Fed rate cuts.

▶ Will the election dynamics between Trump and Harris lead to a more hawkish Fed?

The upcoming U.S. presidential election on November 5th keeps the market tense as investors prepare for a potentially turbulent market period.

Whether Trump or Harris wins the presidency, the U.S. budget deficit is likely to widen, as neither candidate has prioritized deficit reduction in their campaigns. Instead, they focus on economic policies such as increasing government spending, cutting taxes, and economic stimulation that could lead to inflation.

Historically, Republicans tend to implement tax cuts, while Democrats are more likely to push for increased public investment and social welfare spending. These policies could lead to an expansion of the budget deficit, making U.S. government debt a key risk for market participants.

Druckenmiller mentioned in an interview last Wednesday that if Trump is expected to win the next month's U.S. presidential election, the market needs to lower its expectations for the pace and extent of Fed easing. He disclosed that he shorted U.S. bonds to hedge his positions when the Fed announced a 50 basis point rate cut in September.

Bets on falling U.S. bonds now make up 15% to 20% of Druckenmiller's portfolio. Druckenmiller stated that he is unsure how long he will keep this trade, suggesting it could take six months or six years. Additionally, he expressed concern about "fiscal recklessness from both parties."

▶ U.S. bond ETF option implied volatility levels have reached new highs

In the options market, implied volatility is an expectation of future volatility of the underlying asset.When the level of implied volatility rises, it indicates that the market expects greater price fluctuations of the underlying assets in the future.

According to Barchart data, the implied volatility rank of the options for the iShares 20+ Year Treasury Bond ETF (TLT.US) rose to 68 on Tuesday, with the implied volatility percentile reaching 96%.

According to data from Unusualwhales, on October 17th, 23,400 call options with a strike price of $95 expiring on January 7th, 2025, were sold, involving nearly $6 million.