Merlin Weekly Macro: Is there method to Trump’s madness?

“Brutal!”. That was how one trader described the Everest-like ascent of government bond yields this week and prices tumbled precipitously in the opposite direction.

2025 has begun in the same vein as 2024 ended, with headlines neither Sir Keir Starmer nor Rachel Reeves wanted to see. A stagnant economy. Business confidence collapsing. Job vacancies evaporating. Company investment and hiring plans being pared back. Sticky inflation. Weaker sterling. And now, soaring government borrowing costs despite official base interest rates gradually reducing.

The UK is not unique in seeing government bond yields¹ rising rapidly. At the 10-year level measured in ‘basis points’ (each basis point is one hundredth of a percentage point, i.e. 100bp is one percentage point) over a month there have been big increases: in the US (+49bp to 4.7%), Germany (+44bp to 2.6%), France (+52bp to 3.4%), Italy (+51bp to 3.7%) to go alongside the UK’s (+56bp to 4.8%).

Trump lobs grenades with the pin out

The overarching anxiety is Donald Trump, specifically his prospective trade war brought about by the imposition of inflationary tariffs on all US imports. Also his insistence that NATO members are going to have to spend significantly more on defence than at present to guarantee that the Americans turn out to help in the event of an attack on a member state.

The limbo period ahead of his inauguration on the 20^th of January is particularly difficult. Everyone knows the broad direction of travel but with such a mercurial prospective president nobody knows what new cowpats lie on the path. Ahead of being in office, Trump is blithely throwing random tariff numbers about with the abandon of tossing confetti. Are they the first numbers that come into his head? Are they deliberately designed to confuse? Are they bargaining chips? We know he plans a big surcharge for China on top of the blanket 10% rate to be levied globally; but then he casually shoves Denmark (he wants Greenland, something he said in his first term) and Canada (the “51^st State”) and Panama (Trump wants to control the canal) in the firing line to be singled out for punitive measures. From a security standpoint and his philosophy of Make America Great Again his targets are not irrational however unlikely he is to achieve them legitimately. There is an adage, ‘method in the madness’; in Trump’s case it is more that there is an outrageous madness in the method. In this instance Trump is enjoying being the playground bully. He cannot go snatching other people’s belongings just because he wants them.  His means of trying to achieve his ends are corrosive with his allies and neighbours and expensive for everyone as markets take a dim view and hike borrowing costs to reflect the higher risk that he does something stupid.

The wheels come loose on Reeves’s wagon

However, while bond yields have been rising simultaneously there are idiosyncratic preoccupations that are nothing to do with Trump’s foibles and everything to do with national structural problems.

In the UK, whether Starmer admits it or not, investors are deeply unimpressed with his Chancellor’s budget. While Labour undeniably inherited a weak financial position from the Conservatives, Reeves has made a bad situation worse. Given the magnitude of the budget measures and where the pain was inflicted particularly on companies, and her endless bold repetition that “these are my choices” as she delivered her speech, the collapse in business and investor confidence can only be blamed on Reeves. As she teeters on the brink of being in breach of the fiscal deficit and borrowing rules which she herself imposed only three months ago and risks a volte face in the March spending review and having to make swingeing public spending cuts and/or raiding the tax coffers again, her predicament is entirely of her own making.

The economy is flat-lining at best. The real rate of interest the government is paying on its bonds after adjusting for inflation is 2.2% for 10 years and 2.8% over 30 years. For almost all the period from the Global Financial Crisis to the pandemic, it benefited from favourable negative real rates. As if that shift from a tailwind to a headwind is not big enough, a current positive real rate of interest is being charged on a nominal debt of £2.8 trillion when in 2019 the debt was a third less at £1.8 trillion (for the record in July 2020 the nominal cost of borrowing as measured through the 10-Year government bond yield was zero). The annual financial cost of servicing the debt has risen from £45 billion in 2018/19 to over £100 billion in 2023/4. That she has left herself with zero wiggle-room smacks of a toxic mixture of hubris and incompetence much more than being a victim of circumstance (‘hubris’ is an appropriate description: defined in Greek tragedy as “excessive pride or defiance of the gods, leading to nemesis”).

Spending cuts are on the cards. However, we all know that is mere sticking plaster on a gaping wound. Fiscal cauterisation will only be achieved through full-scale public sector reform. Under this government that remains as elusive as a silver unicorn.

Europe has its own problems not indivisible from…

In Europe, the fiscal and the political met in a titanic clash at the end of 2024. The governments of both Germany and France imploded. Unless the new prime minister produces an unlikely rabbit from a hat, France is in limbo until after mid-summer when a year will have elapsed from the last general election and a new one will be allowed. Germany goes to the polls at the end of February. France has a deficit which needs halving; Germany is not allowed a deficit and needs one to get moving. Both are difficult squares to circle unless their respective political logjams can be broken. One of the major problems confronting Europe but particularly Germany is the reliance on China as an export destination.

…those of China

Which neatly segways on to the major economy in which bond yields are diving rather than rocketing. As China struggles to attain (let alone sustain) its 5% economic growth target and battles deflationary pressures, the Chinese government 10-Year bond yield has sunk to its lowest level in the modern era; at the time of writing it is 1.6% having fallen almost consistently for a decade since 2015 when it was 4.6%. Having begun quantitative easing (the purchase of government bonds by the central bank) towards the end of last year, The People’s Bank of China this year has already announced a further significant shift in monetary policy, focusing in future on interest rate policy as an alternative to making more credit available to try and boost economic growth. It is a curiosity of the state of the global economy that its two biggest participants, the US (25% of the global economy) and China (18%) are both relaxing monetary policy with diametrically opposite results in bond yields.

Will Trump’s first punch-up be in Washington?

Finally, coming back to the US again and its own structural problems. The President has substantial legislative powers through Presidential Decree. But what the President cannot do is bypass Congress on fiscal matters and the budget. Donald Trump might have a clean sweep across the White House and Congress but he does not have control over how Republican Congress members vote. In the House, Republican Representatives have already put down their marker that they are no push-overs by forcing a second vote on the reappointment of Mike Johnson as Speaker, a man endorsed by Trump. Republican Senators forced the withdrawal of Matt Gaetz as candidate to be Attorney General.

The US is nursing its highest public debt in history at $36.1 trillion, 122% of GDP; its last reported deficit was 6.2% of GDP in 2023 and is likely to have been higher in 2024. Government borrowing costs are their highest since 2007. Will it be a majority Republican Congress which finally says that enough is enough? In 2024, government spending was 36.5% of GDP; what would be the effect on the economy if a budget were proposed that cut the deficit to below, say, 4% of GDP, or brought government spending back closer to the long-term non-pandemic average of below 35%? The answer would prove either way the extent to which the recent resilience in growth has been propped up by government spending or it has a natural momentum of its own.

In the meantime, the government debt ceiling mandated by Congress is due to be reimposed in January having been in suspense since June 2023. When it was breached by the Biden administration in January 2023, the ceiling was $31.4 trillion; kicking the can down the road through a failure to agree a new limit casually allowed the debt to increase by 15%, $4.7 trillion, completely under its own momentum. US fiscal responsibility is immensely important to the global financial system; while everyone is focused on Trump’s tariffs and whether he is going to wage war on Denmark, Panama and Canada, or end the war in Ukraine, it is quite possible his first battle is going to be a fiscal one, much closer to home in Congress over how much the government can borrow.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.
 

Sources

¹A yield is the rate of interest or income on an investment, usually expressed as a percentage.