US Election uncertainty fuels fears of inflation and bond market turmoil

As the US presidential election draws near, financial markets are grappling with mounting concerns over inflation and the potential return of "bond vigilantes", investors who drive up bond yields by rejecting government debt according to a detailed report by CNBC.

The possibility of Donald Trump’s victory is intensifying these worries, with many speculating that his economic policies could stir inflationary pressures and spark a rise in bond yields. This, in turn, would hurt the value of fixed-income investments, which move inversely to bond yields.

Bond yields have been volatile

Bond yields have been volatile since mid-September, driven by a mix of political uncertainty and economic factors. The Federal Reserve’s decision to lower interest rates in September, intended to boost economic activity, has triggered fears of stronger economic growth and higher inflation. Coupled with the US government’s mounting budget deficit, which exceeded $1.8 trillion in fiscal 2024, these developments have raised concerns among bond investors about the growing risk of holding Treasury securities.

ED Yardeni has warned investors

Ed Yardeni, economist and founder of Yardeni Research, warned that the bond market could push the 10-year Treasury yield above 5 per cent, a level not seen since 2007. This could signal a return of the bond vigilantes, traders who could force the government to address its fiscal policy by selling off debt or demanding higher yields. Yardeni cautioned that the Fed’s interest rate cuts could be seen as too aggressive and could further stoke inflation expectations, adding to the pressure on bond markets.

The rising deficit and the possibility of higher inflation are particularly concerning under both presidential candidates. While Vice President Kamala Harris has maintained the fiscal policies of the Biden administration, which have contributed to the highest inflation in four decades, Trump’s proposed policies are stoking even greater fears.

His intentions to increase tariffs and expand deportations, combined with his reported interest in exerting control over the Federal Reserve, are seen by some as a recipe for economic contraction, higher inflation, and potential damage to US trade-exposed sectors like manufacturing and agriculture.

A recent report from the Peterson Institute for International Economics warned that Trump’s policies could lead to lower national income, higher inflation, and increased economic damage, with long-term repercussions.

Meanwhile, Wall Street analysts have offered mixed views on the implications of a Trump presidency. Morgan Stanley predicts Trump’s protectionist policies could shave off 1.4 per cent from economic growth and raise inflation by nearly 1 per cent. JPMorgan, on the other hand, flagged a “red sweep” of Republican policies as a potential tail risk for the economy, explaining the possibility of stagflation driven by higher tariffs and mass deportations.

However, there is some debate. During his first term, Trump’s tariffs didn’t lead to runaway inflation, with the inflation rate staying below 3 per cent throughout his presidency.

Despite the concerns, some analysts believe that economic growth will normalize after 2025, easing the pressure on bond markets. Evercore ISI, for example, forecasts a modest increase in inflation under Trump but anticipates only a small uptick in the Fed's baseline interest rate compared to a Harris administration.

As the election results approach, the bond market remains on edge, but analysts predict that regardless of the outcome, the uncertainty fuelling market volatility will likely subside in the months following the election. In the meantime, both bond investors and stock market participants will be closely watching the unfolding political landscape for signs of the economic direction ahead.