With the election nearing its conclusion, concerns about 'bond vigilantes' and inflation intensify in financial markets.

• If Donald Trump wins the election against Kamala Harris, there is a possibility that increasing fiscal deficits and a potential global trade war could lead to higher inflation and rising bond yields.
• In the 1980s, Ed Yardeni, an investor, introduced the term "bond vigilantes" and warned that they might reappear as government debt and deficits increased.
• The Peterson Institute for International Economics presented a grim outlook for the country's financial and economic well-being, as well as inflation, under a Trump administration.
• Despite Trump frequently discussing the possibility of tariff-induced inflation spikes during his first term, inflation never exceeded 3% in any month of his presidency.

The possibility of Donald Trump winning the presidency has influenced financial markets' belief that his policies could stimulate economic growth and inflation.

If Kamala Harris loses to Donald Trump, some predict that increasing fiscal deficits and a possible global trade war could lead to higher inflation and rising bond yields, while the stock market experiences gains.

If yields and prices move in opposite directions, it would negatively impact the value of fixed income. There is a possibility that "bond vigilantes" may return, which are traders who pressure the government to manage its debt by either avoiding it or selling it.

Since the 1980s, investor Ed Yardeni has warned about the return of vigilantes in the bond market, specifically cautioning against traders pushing the bond market benchmark, the , above 5%, a level not seen since mid-2007.

Yardeni wrote in Monday commentary that the Bond Vigilantes are threatening to push the 10-year Treasury yield to 5%, although we are not yet calling for it to reach that level.

What's happening in bonds?

Since mid-September, the bond market has been in turmoil, with political factors such as the possibility of a second Trump term being one of the reasons.

• On Sept. 18, the Federal Reserve reduced its benchmark short-term borrowing rate by half a percentage point. Although this typically leads to a decrease in the yield structure, it instead sparked anticipation of stronger economic growth and, in certain regions, concerns about inflation resulting from easier monetary policy.
• The U.S. government ended Fiscal 2024 with a budget deficit of over $1.8 trillion, with $1.1 trillion of that amount being used to cover financing costs on the $36 trillion national debt.
• Neither Trump nor Harris is discussing fiscal discipline, which is causing investors to worry that they may demand higher yields on Treasury paper, making it less safe to hold.

The Fed and fiscal factors are both being blamed by Yardeni for the current economic situation. It is predicted that the central bank will approve another 0.25% cut at its meeting on Thursday.

"The bond market could easily negate the effects of another rate cut, as it believes the Fed is cutting rates too quickly and too aggressively, leading to an increase in long-term inflation expectations. This is exacerbated by concerns about more fiscal excesses from the next administration."

"According to Komal Sri-Kumar, president of Sri-Kumar Global Strategies, the continuation of large fiscal deficits in a Kamala Harris or Donald Trump presidency, and the lack of discipline in monetary policy, indicate that a much higher yield is necessary. Ignoring this signal could have dire consequences for the Federal Reserve."

Inflation has reached its highest level in over 40 years due to the combination of fiscal generosity and pandemic-related supply and demand factors.

Despite polls showing a neck-and-neck race, online betting sites have raised the odds that Trump could be elected to another term, intensifying the focus on his proposals.

A study sees trouble

The Peterson Institute for International Economics, a nonpartisan think tank, presented a bleak outlook for the country's financial and economic well-being, as well as inflation, under a Trump administration.

Karen Dynan, the author, claimed that Trump's plans to increase tariffs and deportations, as well as rumors about his desire to control the Federal Reserve, would lead to a decrease in US national income, employment, and inflation.

"While economic conditions may recover in some cases, the damage may persist until 2040 in others. Despite Trump's "America first" rhetoric, his policies would harm the US economy more than any other in the world, particularly trade-exposed sectors such as manufacturing and agriculture. In some cases, other countries may experience stronger economic growth after receiving inflows of capital leaving the United States."

The institute has been relatively silent on the implications of a Harris presidency. A recent study suggests that the Democrat's policies are likely to maintain baseline forecasts due to anticipated "minimal modifications to current immigration, trade, and Fed independence policies."

While other voices on Wall Street have issued inflationary warnings about Trump's policies, the Peterson narrative estimated potential inflation under Trump as up to 7.4 percentage points above normal in a Trump presidency.

Recently, Morgan Stanley predicted that the implementation of tariffs and isolationist policies under Trump could lead to a decrease of 1.4% in real economic growth and an increase of 0.9% in headline inflation rates.

The "biggest tail risk" from the election is a "red sweep" for Republicans, which could result in "higher tariffs and mass deportations, triggering stagflation in the US, including a second inflation spike," JPMorgan warned.

The firm pointed out that "Trump has shown a willingness to change his views" and "tail risk is not priced-into markets nor is it actively discussed across the US client base."

Low inflation in Trump's first term

During his first term, Trump frequently discussed the possibility of tariff-induced inflation spikes. However, despite implementing strict tariffs, the 12-month inflation rate never exceeded 3% in his presidency. In contrast, the inflation rate surpassed 9% during the Biden-Harris administration, while economic growth remained steady, except for a brief dip at the start of the Covid pandemic.

Some Wall Street analysts believe that the recent increase in yields may reverse as the Fed continues to cut rates and the macroeconomic growth stabilizes to long-term trends by 2025 and beyond.

Under a Trump presidency, Evercore ISI predicts the possibility of higher inflation, but anticipates it only leading to a 0.25% increase in the Fed's baseline funds rate compared to a Harris presidency. Despite the brief Covid-related bear market, stocks have performed better under Trump than Biden and Harris. Some attribute the recent equity rally to the rising odds of a Trump win.

According to Evercore, in their baseline analysis, the risk-off effects of trade policy uncertainty and the risk-on effects of Trump animal spirits balance each other out. Meanwhile, the Conference Board's monthly sentiment survey for October revealed that the largest share of respondents in its history, dating back to 1987, anticipate higher stock prices in the next year.

Over the past few days, yields have slightly eased, despite a counterintuitive surge of about a quarter percentage point, or 25 basis points, following the Fed move. Some believe that the decline could be in its early stages.

According to market veteran Jim Paulsen, the impact on the bond market from the upcoming election will likely be less than it has been with all the uncertainty leading up to it, regardless of the outcome.

Paulsen introduced the term "yield interruptus" to describe the recent unusual developments, stating that they are likely to continue as long as the economy continues to strengthen. However, there are some key indicators suggesting that economic momentum may soon moderate, potentially ending the current interruption.