Trump tax overhaul bid poses a big risk to U.S. Treasury bulls

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Investors in the world’s largest bond market may need to pay a lot more attention to Washington once more.

The White House has worked out a tax framework with congressional Republican leaders that includes cuts, President Donald Trump said over the weekend, with a speech on the fiscal plan expected on Wednesday.

But markets don’t appear to be pricing in a prospective uptick in the fiscal deficit and associated bond supply—and that’s giving fuel to Treasury bears, emboldened last week by the more-hawkish-than-expected Federal Reserve meeting.

"Any tax reform is likely to increase Treasury supply near term—as they are looking at plans that will rely on increased revenue in the future, after the growth kicks in, to reduce the costs of the plan," Peter Tchir, head of macro strategy at Brean Capital LLC wrote in a client note.

After the post-election selloff on fiscal-stimulus fears, the market isn’t currently projecting any increase in the deficit, according to Citigroup Inc. research, underscoring how tax legislation is a big risk to Treasury longs.

"The GOP’s plan to do away with state and local tax deductibility makes it politically unattainable—so the market seems reluctant to take it seriously," says Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets.

Still, Jabaz Mathai, Citigroup’s chief U.S. rate strategist and former bond bull, warns against complacency. He brought forward his call on Friday that the 10-year note will hit 2.4 percent by the end of the year, from a previous projection of the first quarter of 2018.

Tchir recommends investors underweight or short 10-year obligations, citing the likely resurgence of the Trump trade that should firm up U.S. price pressures. Inflation-linked bonds and trades betting on a steeper Treasury yield curve between two-year and five-year maturities look cheap, according to Bank of America Corp.

Strategists at Bank of America say tax cuts would come at a monetary inflexion point: a probable rate hike in December would take the federal-funds rate closer to the economy’s full potential, while leadership changes are on the horizon, with possibly a new Fed chair, vice chair and vice chair for supervision over the next six months.

"This raises the tail risk that easier fiscal policy could be met with slower to adjust monetary policy resulting in central bank ‘behind the curve’ trade in the markets," analysts Shyam Rajan and Carol Zhang wrote last week.

Bloomberg News