Why Donald Trump's Surprise Victory Crashed The U.S. Treasury Market

They said he couldn't win. They said if he did, the stock market would crash. Well, he did and it didn't. But long bonds did.

Donald Trump's surprising win in the U.S. presidential election sent global financial markets for quite the joyride. Doomsday predictions were plentiful leading up to Tuesday's vote. Justin Wolfers at the Brookings Institute forecast a 10-15 percent drop if President-elect Trump prevailed. RBC Capital modeled a 10-12 percent decline. Barclays predicted an 11-14 percent sell-off. The consensus opinion in the event of a Trump victory was for a 4-7 percent correction in stocks and modest rally in U.S. treasuries.

When the results came through early Wednesday morning, the base-case scenario looked likely to play out. U.S. stock futures traded limit down, the dollar retreated, Asian markets tanked and gold spiked. However, President-elect Trump stepped on stage in the wee hours of the morning and delivered a very conciliatory acceptance speech, giving investors hope he would moderate the sometimes-abrasive tone of his campaign and focus on the pursuit of pro-growth policies. The Dow and S&P 500 recovered all prior losses by early in Wednesday's session before making new all-time intraday highs the following day.

The stock market reversal was surprising most, but the more shocking move came in bond markets. Yields on U.S. treasuries soared in anticipation of higher growth and inflation under President-elect Trump. Yield on the 10-year U.S. treasury climbed 20 basis points on Wednesday. Yield on the U.S. 30-year surged 23 basis points. And it wasn't a fake-out. The 30-year added another 10 basis points in yield over the next two days, finishing the week at 2.95 percent, its highest level since early January. By Thursday the 30-year break-even rate, a measure of inflation expectations, spiked to 2.08 percent, its highest point in two years. The magnitude of the four-day spike in 10-year Treasury yields was the largest in nearly two-and-a-half years, representing three standard deviations from implied volatility. From lows just after midnight Wednesday morning to highs on Friday the 10-year added 42 basis points of yield, closing at 2.14 percent.

With the benefit of hindsight, it's hard to see how forecasters got it so wrong. Almost every one of President-elect Trump's policies are highly inflationary. He has pledged to pass a $1 trillion infrastructure bill. Doing shock-and-awe fiscal stimulus in the latter stages of a business cycle - just as inflation begins to accelerate due to a tight labor market - is akin to throwing gasoline on a fire. He pledges to roll back banking and energy regulation, which should stimulate growth. He plans to reduce the corporate tax rate to 15 percent, which would add nearly $800 billion to headline GDP according to the non-partisan Tax Foundation.

Even the incoming President's more controversial plans are inflationary. With the economy near full employment, mass deportations would trigger a labor shortage, causing wages to rise. Imposing tariffs would raise consumer and producer prices. During the campaign, he also suggested America should consider renegotiating its national debt. Although unlikely, such a scenario would trigger a U.S. sovereign credit rating downgrade/default and cause borrowing costs to soar. We'll know soon whether foreign holders of U.S. treasuries sold bonds en masse amid the uncertain debt picture.

Many pointed to parallels between this week's action and the post-Brexit rally in Britain's FTSE 100 index, but the moves were completely different in nature. The surge in British risk assets was driven almost entirely by currency factors. With the blue-chip FTSE index deriving nearly 70 percent of its profits from multinational corporations, the sharp drop in the pound was stimulative to earnings on an accounting basis. After Tuesday's election, the dollar rallied alongside the stock market, with the greenback enjoying its best week in a year.

Ironically, the big currency winner in this week's mayhem: the pound, which rallied against all 31 major currencies comprising its trade-weighted basket. The worst performer? The Mexican peso, which fell 10 percent immediately following President-elect Trump's victory and continued to bleed lower all week. Analysts expect the peso's slide to continue, with Nomura projecting a 25 percent depreciation. Mexican President Enrique Pena Nieto has already expressed a willingness to work with the incoming U.S. president on revised North American Free Trade Agreement (NAFTA) terms.

Not everyone got the result, and subsequent market reaction, wrong. On Wall Street Week earlier this year "bond king" Jeffrey Gundlach of DoubleLine Capital predicted a Donald Trump victory. He also said a Trump victory would be positive for stocks and negative for bonds due to higher inflation expectations. Gundlach ended up being dead right, although he didn't bet on it. Carl Icahn didn't make such a bold proclamation, but he did support Donald Trump during the campaign. When the candidate emerged victorious Icahn left the after-party to plow $1 billion into stock futures, which at the time were down 5 percent. Needless to say, the decision paid off handsomely.

Implied odds of a December rate hike also swung wildly this week. Expectations for a tightening next month entered the week at 84 percent, but briefly plummeted below 50 percent early Wednesday morning amid market turmoil. However, with risk assets resurgent and inflation expectations running rampant, by Friday's close odds were back up to 81 percent. If President-elect Trump is able to pass his massive infrastructure bill, the Fed could actually have to quicken the pace of its monetary tightening.

Pre-election prospects of a December rate hike had already taken the shine off emerging markets, but the phenomenon accelerated as inflation expectations spiked following Donald Trump's victory. Fast-rising U.S. Treasury yields weakened the appeal of riskier government debt causing emerging market carry trades to unwind at their fastest pace since 2011. A Bloomberg gauge of carry trades in eight developing-nation currencies tumbled 3.8 percent Wednesday and Thursday as spreads between "risk-free" treasuries and emerging-market bonds narrowed to a 16-month low.

The list of assets experiencing violent volatility goes on. In Japan, the Topix index closed 4.6 percent lower Wednesday before rallying 6 percent Thursday. Oil fell by around 4 percent before recovering all losses. Gold initially spiked 2 percent Wednesday morning, but fell 6.5 percent from its highs the rest of the week. Copper had its best week in five years, rallying 4 percent Thursday to its highest level in 16 months on President-elect Trump's infrastructure plan.

The surprising election result also sent several equity sectors soaring. Bank stocks around the world screamed higher due to rising yields and Donald Trump's campaign promise to repeal oppressive portions of Dodd-Frank post-crisis financial regulation. The S&P 500 bank sub-sector rallied 10.2 percent in the three days following Trump's victory, its best three-day performance since August 2009 - and it could be just the beginning. Even the beleaguered Stoxx Europe 600 banking index rallied 9 percent, its best weekly performance since December 2011. Pharmaceutical stocks, which had underperformed broader markets during the campaign due to Hillary Clinton's support of price caps, soared. Gun stocks, robbed of their most effective sales pitch (the liberal President is coming to steal your weapons any day now - buy while you can!), plummeted. Healthcare services and hospital companies benefiting from Obamacare plummeted amid expectations the program would be repealed. Inflation impairs the value of future cash flows, so growth-oriented tech stocks were the big loser. With the S&P and Dow rallying to new highs Thursday, the Nasdaq fell nearly 2 percent. Amazon (-3.9 percent) and Netflix (-5.5 percent), two companies with high earnings multiples, were among the biggest losers.

Markets had been relatively subdued during the six months prior to the election, but if last week's action is any indication, don't expect boring any longer - and that's good for alpha generation.