Trump as President Could Surprise on the Upside
The question that many investors have is whether U.S. President-elect Donald Trump’s victory constitutes a real breach from the perspective of financial markets. Until now, the answer is no.
No one has been able to predict the exact measures that Trump will implement once he is in office—not even him.
However, in order to achieve its ambitious Keynesian-inspired recovery program ($500 billion targeting infrastructures), he will have to issue more public debt to finance it.
Under such circumstances, Trump will have to break his promise to raise tariffs against China because the country, which is the main holder of U.S. foreign debt (treasury bonds worth $1.157 trillion as of last September), could decide to reduce its purchases in case the new U.S. government decides on hostile trade measures.
The high level of public debt of the U.S. makes the country extremely dependent on the goodwill of foreign investors, which makes it impossible to implement protectionist measures at an extended level.
The most credible scenario will likely be an increase in tariffs for certain targeted products, which could satisfy Trump’s electoral base and has the advantage of avoiding a trade war with Asia.
The Trump Effect on Inflation
As many investors have observed, the Trump effect will mostly be found in a strong boost of investor-inflation expectations. The market believes that Trump’s expansionary fiscal policy, trade protectionism and labor immigration restrictions will substantially push inflation up during his term.
As a consequence, the break-even inflation rate for the U.S. has increased significantly in recent weeks, recording 1.97 percent for three years and 2 percent for five years.
The five-year inflation forwards confirm this trend since they have witnessed an increase from 2.14 percent at the beginning of November to 2.46 percent currently.
One could argue that the Trump effect on inflation is likely to fall flat.
However, one should not forget that the underlying trend that explains most of the increase in inflation expectations is linked to higher global commodity prices and the slow exit of China from deflation.
Business as Usual
Victory is not really expected to change the course of the U.S. monetary policy.
The Fed has a window of opportunity until February 2018, which corresponds to the end of Janet Yellen’s mandate, to continue to hike interest rates.
Replacing Yellen before this deadline has zero chance of happening.
The U.S. president-elect may invoke only two legal clauses to replace a member of the Federal Open Market Committee (FOMC).
The first one consists of invoking “serious misconduct.”
However, although this legal term remains open to interpretation, there is nothing to suggest that Yellen has ever committed such a crime.
The second lever that Trump could use is to keep Yellen as the chair of the Fed’s Board of Governors, but at the same time reduce the room for her to maneuver.
To do so, the statutes of the Fed must be amended, which requires a simple majority in the Congress and a presidential approval.
Nevertheless, it is quite unlikely that such a decision will obtain the support of the Republican Party.
Therefore, the process of normalizing U.S. monetary policy will certainly not be influenced by the political change in Washington D.C.
The increase in rates in December could be a non-event because it has already been priced in the market, especially in the Dollar Index which has risen by around 4 percent since November.
All data (including Taylor rule and investor expectations) confirm that the Fed will hike rates at its next meeting.
The Taylor rule (which has been a very useful tool for the Fed since early 1990s) indicates that the weighted average interest rate should be slightly above 2 percent at the end of Janet Yellen’s term.
However, this theoretical level remains insufficient to cope with the inevitable economic slowdown in the U.S.
The latest indicators confirm the economy is healthy, but it is approaching the end of the business cycle. Since the last economic downturn, 35 quarters have passed.
Except a new record of longevity (40 quarters during Clinton’s golden age), the U.S. will face a new recession during Trump’s presidency.
In this context, we believe the president-elect’s Keynesian economic program could be of a great help to stimulate the economy when it will be needed the most, especially if the Fed does not have enough room to lower interest rate and reassure investors.
Christopher Dembik is the Head of Macro Strategy, Saxo Bank