Rates: You think you’ve seen it all? Wait for it…

While there is confusion and uncertainty in the air in the US, we know far more now than we did before election day.

The outcome being baked into market price action looks beyond potential re-counts or election validity objections that can muddy things in the coming weeks. The focus is squarely on a Joe Biden administration outcome, but constrained, as the Republicans keep the Senate. And crucially, so far, markets are concentrating on the positives from this. Hence the buying of risky assets like equities.

Where congress acts as a policy bloc to Biden in the coming years, some of the more extreme policies are watered down. Such gridlock gives Wall street less to stress about

But what about bonds? Typically when equities are in favour, bonds are not, and yields head higher in consequence. Here, the impact effect has seen the 10-year US yield lurch lower, from 95bp to 75bp. A 20bp move is a huge move in proportion to the absolute level of yield. In the bond world, these are big valuation changes over the course of 24 hours.

Now we ask a two-pronged question, why have we had this impact, and more importantly, where do we go from here.

The rationale for the fall in yields reflects a relief factor.

An unconstrained Biden outcome had positives as it would likely come with a large stimulative package, which would then need to be financed. That combination would be good for growth, but also heavier on supply. In contrast, a constrained Biden likely means a smaller stimulus, with means less of a boost for growth and a smaller increased in supply.

This backdrop together, with an extrapolation where Congress acts as a policy bloc to Biden in the coming years, means that some of the more extreme policies are watered down.

Such gridlock gives Wall street less to stress about, which in part helps to answer the second question. The prognosis remains in place for a 2021 recovery. A boost to growth would ease supply concerns, as the economy keeps better pace with the debt. This maintains a view for a 1 handle for the US 10yr yield in 2021.

While a 1 handle for the US 10yr may not appear to be an aggressive call, it is by definition a definite separation from the negative rates world that the Eurozone continues to endure. The prognosis here is for a re-widening in the spread between US and German market rates.

Pre-Covid, the 10yr spread was over 2%. Covid took it to 1%. It should be in the 1.5% to 2% area as a theme in the quarters ahead. Resumed steepening pressure will also likely come from the US, which is good as it means that the curve is discounting reflation of the economy.