Analysis

Trump's momentous victory in the US presidential election on November 8 has led to a surge in volatility in financial markets.

The initial reaction to Trump's triumph was one of near panic. US equity futures plummeted to such an extent that they triggered trading curbs designed to limit sharp price falls in times of financial turmoil.

The Mexican peso, a proxy for investor perceptions of US political risk, plunged more than 13% to a record low to the dollar on November 9 before moderating -- but still fell the most in one day since the 1994 'Tequila crisis'.

Equity markets excited by tax and spending ideas ...

By midday on November 9, equity markets started to recover as the 'flight to safety' began to unwind. The benchmark US S&P 500 equity index even rose to a one-month high on hopes that the tax and spending plans proposed during the campaign would boost short-term growth prospects. Indeed, the Vix index, Wall Street's 'fear gauge' which measures the anticipated price swings in US stocks, fell more than 20% to its lowest level since late October.

... but bonds burdened by inflation fears

Bond markets did not recover though. In a sign of the nervousness about the fiscal and economic policies of a Trump administration, the US bond market suffered a sharp sell-off, with the yield on the benchmark ten-year Treasury note surging above 2% to its highest level since January. The yield closed the week at 2.15%.

The 'steepening' of the Treasury yield curve, with long-term yields rising faster than short-term yields, stems from Trump's pledge to launch a 1-trillion-dollar fiscal stimulus plan. If this is implemented, it will significantly increase the US federal debt burden. This would be likely to spur inflation, which might force the Federal Reserve to tighten monetary policy more aggressively.

Sovereign bond markets were already under strain before the US election because of a rise in inflation in advanced economies -- particularly in the United Kingdom and the United States (see PROSPECTS 2017: Global economy - November 2, 2016). The prospect of a significant fiscal expansion based on Trump's pledge to invest heavily in infrastructure and slash corporate taxes has led to a much sharper decline in the price of government bonds.

Bonds and equities diverge

According to Bloomberg, more than 1 trillion dollars has been wiped off the value of global sovereign debt since Trump's victory, while global equities have gained more than 1.3 trillion dollars in the same period, highlighting the remarkable post-election divergence in the performance of asset classes. Investors ploughed more than 5 billion dollars into US equity funds in the week ending November 9, with the bulk of the inflows occurring after the US election result.

From a debt market perspective, the fear is that Trump's victory will be the catalyst for the long-anticipated 'great rotation' out of bonds and into equities. Yields on benchmark German bonds have risen a further 20 basis points since the US election, while their Italian equivalents have shot up more than 30 basis points to their highest level since mid-2015.

If Trump's stimulus plans materialise -- and the scale of his victory, with the Republican party now in control of both houses of Congress, makes this more likely -- the Fed could be forced to raise rates more aggressively.

The odds of a US rate increase at the Fed's next policy meeting on December 13-14, as predicted by futures markets, fell from 80% to 50% in the hours following Trump's victory. However, they have risen since as investors have focused on the inflationary impact of Trump's fiscal stimulus plan.

Given the high level of uncertainty about the foreign, economic and monetary policy of the incoming administration, the Fed may remain cautious ahead of Trump's inauguration in January, monitoring data and speeches ahead of the meeting very closely.

Flight to safety

Emerging market (EM) assets have suffered in the wake of Trump's victory as a result of the sharp rise in Treasury yields and the surge in the dollar.

The dollar index, a gauge of the greenback's performance against a basket of its peers, has risen to its highest level since the end of January. EM bond funds, which enjoyed a 20-week-long streak of inflows to the election, are now estimated to be suffering outflows.

EM currencies, according to JPMorgan's benchmark EM Currency Index, experienced their sharpest weekly decline since September 2011 last week -- an even sharper fall than the one suffered at the outset of the so-called 'taper tantrum' in May 2013.

Investors will continue to discriminate between EMs on the basis of macroeconomic fundamentals and growth prospects (see INTERNATIONAL: Emerging market assets resilient - November 4, 2016). Though the timing and scale of Trump's trade and immigration policies are uncertain, the Mexican economy is expected to be the greatest casualty (see MEXICO: Peso and US relations may struggle - October 13, 2016).

The Mexican peso, a barometer of 'Trump risk', has fallen by more than 10% since the US election. Goldman Sachs has warned that the fierceness of the sell-off in bond markets represents a "potentially destabilising" development for broader financial markets.