Donald Trump is back in the White House with a pledge to reinforce his ``America First’’ agenda. Higher tariffs and curtailing immigration are among his key policy promises. His return introduces a new dimension to the US economy’s prospects, which will have a bearing on the Federal Reserve’s (Fed) next moves and the direction of the markets.
Higher tariffs will certainly push up the cost of imported goods for American consumers. Trump’s tariff policy is aimed at expanding local manufacturing capacity as higher import duties could force foreign companies to consider the US as an investment destination. Soon after assuming office, Trump threatened to impose tariffs of up to 25% on imports from Canada and Mexico, and 100% on China. He also said he’ll impose tariffs on Europe if it didn’t buy more American oil.
The president has vowed to crack down on immigration, which could reduce labour supply and boost nominal wages eroded by years of globalisation. The Fed as well as investors have been kept guessing about the direction and nature of inflation for the best part of the past year. We believe Trump’s policies could add to that uncertainty.
The Fed has brought inflation under some control from the peak seen after Covid, thanks to a series of interest rate hikes. Chair Jay Powell kicked off the rate cutting cycle in September, much later than expected by markets. Inflation is still hovering above the central bank’s 2% target, prompting the Fed to tone down expectations for further rate cuts. The markets too have sharply scaled back their rate cut hopes with just one 25 basis point cut expected this year.
Trump’s ascendancy has raised many questions, including whether the Fed will remain independent. Powell has said that he’ll not quit his job if asked by the president. Lingering inflation also keeps alive the threat of higher policy rates. The diagram below analyses various possible scenarios and what that might mean for the economy and markets.
The US economy’s growth is underpinned by a combination of strong fiscal spending and robust balance sheets of corporates and households. This has kept inflation sticky, dashing hopes that interest rates could return to the level seen after the Global Financial Crisis. Supply-side pressures such as high oil prices, driven by geopolitical tensions, too are adding to inflation.
Inflationary expectations have increased, prompting fixed income investors, led by bond vigilantes, to seek their pound of flesh. The recent spike in US Treasury yields is a manifestation of this, which in turn has pushed up yields across much of the developed world. Investors are demanding higher term premium as a protection against inflation, steepening the yield curve.
In the UK, the problem is compounded by a deteriorating fiscal situation, leading to a selloff in gilts, which pushed long-term yields to the highest level since 1998. Ten-year yields have risen by 25 basis points since Chancellor Rachel Reeves’ budget in October, and a cut in spending is required to restore confidence. It’s fair to say that gilts have suffered more than other sovereign bonds as the UK is one of the few major economies with the dubious distinction of grappling with both a large current account deficit and a fiscal deficit. This pain is demonstrated in the underperformance of gilts versus bunds.
UK yield premium over Germany - Highest since 1990
Too much borrowing to meet expenditure as well as reliance on foreign capital to fund the deficit has been the bane for gilts. In this environment, the bond curve in the UK needs to be steeper to find buyers. Capital is scarce now. The post-GFC world of ultra-low interest rates doesn’t exist anymore as QE is a thing of the past. The UK is slipping into a debt spiral as yields are rising faster than economic growth. Higher borrowing costs have increased the cost of servicing existing debt, requiring the government to borrow even more.
While the budget deficit in the US too has burgeoned over the past few years, the primacy of the dollar as a reserve currency lends the US Treasuries a distinct advantage. However, rampant bond issuance is pushing up borrowing costs and keeping policy rates higher. This could widen the difference in the yield of US Treasuries versus the rest of the world, attracting further capital flows and strengthening the dollar. Inevitably, a sustained strength in dollar forces overseas investors to sell dollar-based assets, tightening financial conditions. This typically triggers the Fed to ease its policy. One should look at the US current account deficit for clues on the Fed’s policy path.
US long-end yields have risen sharply since the Fed started cutting interest rates in September. This is very unusual as yields typically tend to decline in an easing cycle and highlights investors angst over rampant borrowing, fiscal spending and sticky inflation. It’s generally assumed that Trump’s policies will lead to a wider fiscal deficit but given his preference for a robust stock market, it remains to be seen whether he’ll take the risk of disregarding the adverse signals sent by bond markets.
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