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posted on 03 June 2017

Muni-Bond Market Says Trump's Tax Cuts Are Dead

Written by , Clarity Financial

Since the election, much of the reasoning behind the surge higher in asset prices has been the expected tax cut/reform from the Trump administration which, as the theory goes, would lead to a surge in economic growth, higher inflation, and subsequently higher bond yields.

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Unfortunately, given the lack of progress on the ACA replacement/repeal, the harsh pushback and criticism of Trump’s proposed budget, and the ongoing investigations and inner turmoil of the Trump Administration, the likelihood of tax cuts is becoming a much more distant reality. As such, the municipal bond market (and the Treasury market) have begun to aggressively discount the probability of significant tax reform any time soon.

Furthermore, the whole “reflation" trade also seems to come down to a similar agreement about the possibility of the Trump Administration to achieve any of its policy goals. As shown below, the Dollar/Interest Rate trend is clearly negative.

As RBC macro strategist Mark Orsley wrote a week ago Friday:

“I am finding it increasingly difficult to see a near-term catalyst for UST’s to sell off. In fact, almost all indicators I watch are flashing a warning that a breakdown in yields (longer end) is increasingly probable."

I have long been discussing that a move to 2% or below is quite likely (see here) but as Orsley points out:

“Technicals -> two head and shoulder formations point to lower yields. Target of 2.05% on the Feb/March formation, and if 2.17% gives way, the H&S from April/May targets 1.95%. Notice the MACD starting to trend lower…"

He is correct. A breakdown in yields will likely come with the realization that current earnings projections are far too optimistic to support current market valuations which will likely be coupled with concerns of a recessionary onset from further Fed rate hikes. Any rallies in rates back to 2.4% should likely be used to add additional exposure to bonds for a trade in the weeks ahead.

As Orsley concludes:

It may seem like a no-brainer to short at these levels into a Fed hike (at least this time the market isn’t going in at the yield highs), but all the above indicators should serve as a warning to bond bears. Despite cleaner short positioning, the pain trade still remains lower yields.

I agree.

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