Monthly fixed-income focus

U.S. election results hold implications for fixed income

What you need to know

• Post-election, key policy priorities have emerged: income tax cuts, tariffs, deregulation and immigration reform.
• Extending the 2017 Tax Cuts and Jobs Act and deregulation are likely to boost economic growth and corporate profits, contributing to a steeper yield curve and tighter credit spreads.
• Tariffs could raise import prices, while immigration reform could drive labor costs higher if labor markets tighten, driving inflation expectations higher.
• Tax cuts generally reduce government revenues, which, if not offset by economic growth or spending cuts, could drive deficits and debt higher.

Portfolio tip

Consider extending duration with intermediate-term bonds and bond funds to help lock in higher yields for longer. Intermediate-term bonds should be less sensitive than long-term bonds to the risk of yields rising further. Bond prices typically rise in value when interest rates fall, and vice versa, providing the opportunity for higher values as the Fed likely continues cutting rates.

Growth expectations have narrowed credit spreads

Tax cuts and deregulation could boost economic growth and corporate profits, providing a favorable environment for lower-quality issuers, including U.S. high-yield bonds. Perceived credit risk in this market has declined as a result. Credit spreads — which reflect the excess yield above U.S. Treasury bonds to compensate for default risk — have tightened well below historical averages.

We suggest underweighting U.S. high-yield bonds as we see little opportunity for credit spreads to narrow further. Potential widening of credit spreads could drive yields higher and bond prices lower.

Policy shifts have raised inflation expectations

Proposed tariff hikes, if enacted, could drive prices of imported products higher. The impact on overall inflation, however, may be muted as imports represent about 14% of the U.S. economy, as measured by gross domestic product (GDP). In addition, producers may not be able to fully pass along tariffs to consumers due to competition. Consumers and businesses can typically switch products to limit the impact of higher prices.

Immigration reform, including the proposed deportation of unauthorized workers, could reduce worker availability. If the labor markets tighten, labor costs could rise.

Partially offsetting these effects, less immigration would likely reduce consumption and housing demand, potentially easing inflation. Overall, bond market inflation expectations have risen but remain within the recent range and do not point to a return to elevated inflation.

Bond markets have reduced Fed interest rate cut expectations

Higher inflation would likely limit the Federal Reserve’s ability to cut interest rates while still aiming for its 2% inflation target. The federal funds rate typically needs to be more than 1% above inflation for monetary policy to be considered restrictive.

Additionally, stronger growth could spur hiring, which, combined with potentially fewer available workers due to immigration reform, could tighten labor markets. This could help the Fed achieve its full employment mandate, reducing the need for rate cuts to support the labor market. Bond markets have reduced Fed rate cut expectations as a result.

Tax cuts could lead to larger government deficits

Tax cuts generally reduce government revenues, which, if not offset by economic growth or spending cuts, would widen deficits. Because deficits lead to higher debt over time, long-term bonds are typically perceived to be riskier because government debt levels will be higher when these bonds mature. Concerns over rising deficits and debt can drive long-term bond yields higher to compensate for this risk, steepening the yield curve.

The proposed extension of the 2017 Tax Cuts and Jobs Act would likely maintain income tax rates near current levels beyond 2025. However, any reduction could negatively impact the value of the tax-exempt income of municipal bonds.