Simply put explores the topic of fiscal budgets this week as the US election fast approaches. With both presidential candidates seeking to expand the US deficit, how might this impact markets and how effectively could diversification shield multi-asset investors?
Bond risk is being repriced
After a period of rising break-even inflation rates, the markets’ attention has now shifted towards real interest rates and, more specifically, to US sovereign risk. Although this risk is relatively contained, fluctuations of a few basis points have contributed to bonds' recent negative performance.
The election is starting to impact market valuations, amid an earnings season that has surpassed expectations. Both presidential candidates propose measures that would further expand the US Treasury deficit, either through increased spending or tax cuts. Although these plans should not, theoretically, impact the budget heavily, the market perceives it differently.
What can we say about this repricing of bond risk? It could have implications for other asset classes, as it influences yield and volatility expectations across the financial markets.
Factors of the bond world
A straightforward method for analysing the various risk factors influencing bond markets, without focusing on a specific point on the yield curve or a particular type of rate, is through principal component analysis (PCA). It allows us to extract a limited number of factors that best explain the fluctuations in a dataset.
We conducted PCA on the rate series – including real rates, break-even inflation rates, and US credit default swaps (CDS) – across various maturities. Given CDS series are relatively illiquid, this technique helps by extracting information related to US sovereign risk from other series. Real rates also partially reflect this risk, as they represent the difference between nominal rates and compensation for inflation.
Figure 1 illustrates the evolution of these factors. The analysis covers the period from 2021 to 2024, during which US debt notably increased. The graph depicts the rise in inflation risk in 2021, followed by a concurrent rise in real rates and the fiscal premium. Since 13 September, the latter has started to rise, along with the inflation premium, but without an increase in real rates. Monetary policy is indeed perceived as inflationary, but the candidates’ proposals in the US election are, in turn, the source of an increase in US sovereign risk.
FIG 1. Historical evolution of the factors driving US rates1
Three factors, different impacts
This raises the question: to what extent do these risk factors, extracted from rate fluctuations, explain the performance of a global bond index? Specifically, if the inflation premium poses a risk to bonds, is it comparable to the risk arising from the tax premium?
Figure 2 illustrates the sliding correlations between the performance of the Bloomberg Government Bonds Index and the three aforementioned factors over the same timeframe. Although inflation poses a risk that could potentially destabilise the bond market, the correlation of returns to this risk exhibits significant variability. This is not observed with the other two risk factors: real rates and the fiscal premium consistently exert downward pressure on bond yields (at least during the period analysed), demonstrating highly negative and remarkably stable correlations.
FIG 2. Correlation of Bloomberg Government Bond Index performance (hedged in dollars) with US bond market factors2
As the elections draw near, caution is warranted. Should the candidates choose to overlook market sentiment, which underpins the financing of US debt, the repercussions might be severe. So how could other asset classes be affected?
The fiscal premium: a friend in disguise
Not all markets are equal on the playing field of sovereign risk. Looking at markets with a naked eye, you could quickly conclude that the slide in US public finances has not moved markets. However, the benefits of the quantitative techniques we use every day lie precisely in their ability to measure the unobservable.
Figure 3 shows the correlations of various assets with the three factors over the entire 2021 to 2024 period. For all of them, the fiscal premium has a negative influence on their performance, with the exception of the dollar, probably due to its role as an international safe-haven asset.
Note that on the chart, inflation has a positive influence on gold and US equities. Finally, we should bear in mind that the S&P 500 correlates more negatively with the impact of fiscal policy than with the rise in real interest rates, a reflection of monetary policy.
FIG 3. Correlation between the performance of various markets and factors affecting the US bond market (2021-2024)3
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What this means for All Roads
In terms of positioning for our All Roads franchise, the situation is a clear call for diversification and balanced risk-taking across markets. This reflects the philosophy driving our flagship strategy’s long-term 150% market exposure. The process of rebalancing All Roads in favour of bonds has naturally come to a halt, as positive fixed-income market trends have eased and our macro signals have become more neutral. Diversification remains the order of the day at this stage of the cycle.
Simply put, we shouldn't underestimate the influence of the tax issue that comes with the US elections.
To learn more about our All Roads multi-asset strategy, click here.
Macro/nowcasting corner
The most recent evolutions of our proprietary nowcasting indicators for global growth, global inflation surprises and global monetary policy surprises are designed to track the recent progression of macroeconomic factors driving the markets.
Our nowcasting indicators currently show:
- Growth momentum remains good, particularly in the US, and positive surprises have been pouring in again this week
- Global disinflation continues at a pace that is likely to slow over the coming months, a message that should make central bankers cautious
- Monetary policy is likely to remain the friend of the financial markets for the time being, but improving economic data puts our indicator on an upward trajectory
World growth nowcaster: long-term (left) and recent evolution (right)
World inflation nowcaster: long-term (left) and recent evolution (right)
World monetary policy nowcaster: long-term (left) and recent evolution (right)
Reading note: LOIM’s nowcasting indicators gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).
