Article / 15 November 2016 at 14:30 GMT

Buckle up for a bumpy ride as Trump poses problems for the Fed

Managing Partner / Spotlight Group
United Kingdom
  • Policy will shift toward aggressive stimulus, corporate tax breaks
  • This will be good for equities and bad for bonds
  • Expect a two-year boost to the economy before tariffs, inflation bite back
  • Fed's entire character could change within 18 months

By Stephen Pope

It was not meant to be like this. Donald Trump was meant to perform well against Hillary Clinton, but the mathematics of the electoral college were supposed to see her safely across the line. 

But it was not to be. Trump is now president-elect. The billionaire has already started forming his front-line administration staff and signalled a strong shift to a right-of-centre business approach.

Reince Priebus, chairman of the Republican National Committee, will be his chief of staff, meaning he will determine the tone for the new administration and act as a conduit to Congress and the wider reaches of government.

President-elect Trump accused Janet Yellen, above, of being in league 
with the Democrats and of bleeding the economy dry. Photo: Flickr

Stephen Bannon, from the Breitbart News Network, will serve as Trump's chief strategist. That is a clear reward, as  Bannon stepped down as executive chairman to act as Trump's campaign chief.

Markets react to a stimulus pledge

Given that so many political pundits had said that Trump was clearly lacking the requisite qualifications to be president, you would have imagined that the news of his election would have seen a sustained decline in equities, which loathe uncertainty, and a rush to the safety of the US Treasury market.

On election night as Trump edged ever closer toward the required 270 Electoral College votes, we did see tremendous falls in equity futures with the Dow Futures tumbling by 968.10 points from 18,386.50 on November 8 to just 17,418.40 in overnight trading in Asian hours. However, this contract has recovered all the lost ground and more, and hit 18,822.00 by the close on November 14.

In contrast, the US Treasury 10 Year issue, 1.500% August 2016 saw its yield soar from 1.728% on November 8 to 2.073% on November 9. It closed on Monday night at 2.249%.
Dow and T10

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This reaction can be explained by the fact that the president-elect’s economic team has insisted that the Trump administration will press ahead with a massive fiscal stimulus programme worth $1 trillion with a reduction in corporate taxes of up to 20%. This could be the start of a bonfire of red tape regulation and be a major boost to industrial sectors covering defence, manufacturing and pharmaceuticals.

There has been a real upheaval across the asset classes as financials have gained on the back of a new round of deregulation, while the tech sector has been hit on concern that the US will soon be in a trade war with Asia that will impact their supply chains. Since Tuesday, shares in JPMorgan Chase are up by 13.578%; in contrast, Apple shares are down by 4.82%.

Fixed income bonds, especially longer-dated US Treasuries have been hit hard on the expectation of greater debt issuance and an increase in inflation that will result from the step of Federal and state-driven aggregate demand.

The US Treasury 2/10 Year spread has widened from +96.2 basis points one month ago to plus 122.50 basis points, a gain of 26.3 bps.

Anthony Scaramucci, a member of the president elect’s economic advisory council, poured scorn on the budgetary discipline, that is, the austerity promoted by fiscal conservatives in the US and Europe. This is bold talk for a nation that carries a level of debt to GDP at 104%. 

This may will indicate that there will not be a close and harmonious relationship between the White House and the Senate and/or Congress. President Trump may find that unlike being CEO, he cannot just tell people what to do on pain of being summarily dismissed.

While Trump's advisers are likely to pour scorn on budgetary discipline, and create friction between the White House and the Senate and Congress. Photo: iStock

Scaramucci said “Trump is a different type of leader not burdened by rigid ideology. ...He is not dogmatic about policy positions. Rather, he has set bold targets from which to begin negotiations”

Standout objectives look to be a proposal for a repatriation fee of up to 35% for companies that have shipped manufacturing jobs from the US to say, Mexico, and who wish to sell those goods back into the US. However, Trump would like to encourage business enterprises by overseeing corporate tax rates cut to 15% from 35%. It was mooted that if the US followed the UK by reducing corporation taxes to 20% it would add nearly $600 billion to US GDP.

Such a stance will surely bring the 30-year bull rally in bond markets to a halt, as in the US there is a serious risk that the tax cuts being proposed will be unfunded. History is littered with inefficient and wasteful cases of public-private partnerships in the field of infrastructure spending as departments or state legislatures adopt a “use it or lose it” approach.

What next for the Fed?

Treasuries are also being punished as the plans emerging from the Trump camp are going to raise serious questions as to the shape and nature of the Fed. On the campaign trail, Trump was deeply critical of the Fed. After he becomes president on January 20, he could move quickly to reshape it.

One side-effect of the promised stimulus programme would be the creation of the economic circumstance that would allow the Fed to begin accelerating the move away from highly accommodative rates back toward a more normal structure.

The Fed raised rates for the first time in almost 10 years in December 2015, as they planned to start raising their benchmark short-term interest rate, now just below 0.5%. So it could be lowered again to boost economic activity when the next inevitable downturn comes. However, their plans appeared thwarted as inflation kept on a low trajectory and business confidence is lower now than it was in 2011 and 2015. Under such circumstances raising rates out of sheer dogma would harm investment and growth.

The 'sticky' risk of expectations

Maybe the latest signals from the equity and Treasury bond markets will convince the Fed that they are about to see an increase in inflation and inflationary expectations.

Expected inflation has played a central role in the analysis of monetary policy and the business cycle striving to discover how much expectations matter, whether they are adaptive or rational and how quickly they respond to changes in the policy regime.

A measure of US inflation expectations held mostly steady at low levels in October, with limited momentum higher, according to a Federal Reserve Bank of New York survey taken before the November 8 presidential election. The survey of consumer expectations found that inflation is expected to be identical one and three years into the future, per the median.

One year-ahead inflation expectations edged up to 2.6% last month, up from 2.5% in September, which was the survey's lowest recorded level. Three-year ahead expectations were flat at 2.6%, near a record low for the online survey that has shown a gradual decline in both price measures since it began in mid-2013.

The worry I have is that in most macroeconomic models, economic agents update their expectations only periodically. This is because of the costs of collecting and processing information can be time consuming and extremely costly. If the agents in the US economy – that is, government, corporations, banks and individual consumers – assume that inflation will pick up post-January 20, 2017, how long will it be before they recalibrate their expectations?

Blowing bubbles?
Recalibration imminent. Photo: iStock 

What is clear is that the body of academic research proves that the following three critical factors will need to be closely considered by the Fed when it manages the monetary policy of the Trump economy:

  1. There is substantial disagreement within both naive and expert populations about the expected future path of inflation.
  2. There are larger levels of disagreement among consumers than exists among experts.
  3. Even though there are different degrees of disagreement, this tends to exhibit similar time-series patterns, albeit of a different amplitude.

The consequence of the Trump stimulus is likely to be that by January 2019, we may well see a tightening of the US labour market that will drive wages higher. Average hourly earnings in the US increased 10 cents or 0.4% from the previous month in October 2016, after advancing by an upwardly revised 0.3% in September. Compared to the same month of the previous year, wages rose 2.8%, which was the most since June 2009. Average hourly earnings have been rising gradually during 2016, pushing retail prices of goods and services higher to maintain profit margins. Will this be a virtuous or vicious cycle as prices accelerate?

For the Trump stimulus to hold longer than two years, wages will need to keep up with inflation in goods, services and house prices. It all sounds like, as the president elect is fond of saying “...a beautiful thing". However, that's far from assured and no model has ever fully captured how consumers might react to higher levels of inflation.

We hope that the Fed would be willing to correct any over enthusiastic push higher on rates, if after say two years the hoped-for Trump miracle starts to peter out, leaving the price levels higher but economic activity relatively subdued.

Clouds on the horizon 

The economic outlook is haunted by Trump's trade policies. He says he wantsFair Trade” as against “Free Trade”. However were he to deliver on the protectionist agenda that was his clarion call that he so frequently sounded as a candidate, he would harm the economy.

Large tariffs on Chinese and Mexican goods would drive up prices of imports and further spur inflation whilst reducing consumer choice and welfare. There will be a balancing reaction and higher tariffs will mean more inflation but lower growth.

The widespread view in the economics profession that barriers to trade harm economic growth. This view has been supported by an empirical literature in which a variety of indices of openness to international trade have been found to factor positively and significantly in cross-country growth regressions.

The relationship between tariffs and growth is both negative and significant. Among the world’s rich countries in the past 20 years for countries in the top quartile of the world’s income distribution, a general tariff rate increase of 10% leads to a corresponding fall in GDP growth of 1.6%. These estimates were obtained using the Generalized Method of Moments (GMM) dynamic panel (systems) developed by Arellano & Bover (1995) and Blundell & Bond (1998).

The subsequent impact on GDP growth of Trump’s positive stimulus and negative tariff policy would squeeze the Fed and pose a risk to its credibility. It may see Janet Yellen tender her resignation before her term is complete. Two past Fed chairmen, Paul Volcker and Ben Bernanke, stayed on despite a change in the political party in power at the White House. So there is no political reason for her to quit.

But this is the first time in history that the incoming president has so aggressively and openly criticised the Fed and its leadership whilst on the campaign trail. Trump has accused Janet Yellen of being in league with the Democrats and stated that the Fed has bled the economy dry.

Yellen's term as chair ends February 3, 2018. She could stay on as a governor, until 2024, although that is looking unlikely. Similarly, Stanley Fischer’s term as vice-chair ends in June 2018 and he may well also leave the Fed completely.

The upshot is that by mid-2018, five of the seven Fed governors would be Trump appointees. President Obama only appointed four governors in his entire first term and President Reagan appointed just two in his first term.

So in summary, it's best to buckle up as it is certainly going to be a “Bumpy Trumpy Ride”.

— Edited by Robert Ryan

Stephen Pope is managing partner at Spotlight Ideas. Follow Stephen or post your comment below to engage with Saxo Bank's social trading platform.


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