Trump’s fat tails

Good morning. Well, that happened. Today’s Federal Reserve meeting should hold fewer surprises — markets are certain of a 25 basis point cut, given the weak job readings from last week. But the future of the Fed’s rate path is now more uncertain; see below. Let us know if you gained or lost money on the election-betting markets (Rob hedged his Trump bet at the last minute, stupidly, and came out about even): [email protected] and [email protected].

Time to challenge conventional wisdom on Trump and markets

The market has responded to the resounding Republican victory exactly as one would have guessed. For the market, Donald Trump’s big victory means a stronger dollar, more M&A, less regulation, crypto utopia, and higher deficits, inflation, and tariffs. All of that played out neatly yesterday. For example:

• The S&P 500 rose 2.5 per cent; the domestically-focused small caps of the Russell 2000 rose 6 per cent.

• The 10-year Treasury yield rose 15 basis points, two-thirds of which was down to a higher break-even inflation rate, with the remaining 5 basis points from higher real rates. This caps a 70-basis-point run in the 10-year yield since October 1, when Trump’s ascent in the polls and prediction markets took off. 

• The futures market’s prediction for the Fed policy rate in December of 2025 rose 12 basis points; since October, it is up 88 basis points.

• The KBW bank index rose 10 per cent in anticipation of softer-touch regulation and sustained higher interest rates. The biggest gainers were CapitalOne and Discover, on renewed hopes that their merger would be waved through.

• The government-sponsored mortgage guarantors Fannie Mae and Freddie Mac rose on expectations that Trump would restore their profits to shareholders.

• Homebuilders slipped as investors suspect that higher rates will make the house affordability problem worse.

• Dollar stores such as Dollar General and Dollar Tree fell sharply on worries about China tariffs. Dollar Tree, for example, directly imports 40 per cent of what it sells, and the “vast majority” of that comes from China.

The list could go on and on. Investors think they know who they are dealing with in Trump. They probably do. But that “probably” is a bit dangerous here. The man is hard to predict. He is not bound by history or his past statements. The distribution of outcomes for his presidency will have fat tails. So, while the central forecast for markets has to be more of what we saw yesterday, we have to think hard about other possible outcomes.

The central dogma worth challenging is the deficits/inflation/rates/dollar nexus. Consider, in that context, the possibility that the market will restrain Trump.

Start with the popular notion that Trump will appoint a toady to the Fed, who will help accommodate the need for low rates in the face of tax cuts and high spending. Would the bond market put up with this? Stocks?

On the same note, will Trump go ahead with deep tax cuts and sustained spending if inflation reignites, and markets take fright? Trump likes to use markets as a measure of his performance. From 2016-2020, both bonds and stock markets co-operated with his ego. Stocks had a nasty period in the fourth quarter of 2018, and fell for the first month of the Covid-19 crisis. Otherwise they rose. Rates were either low or very low. We simply do not know how he will behave in the face of sustained market hostility. It might scare him into economic conventionality.

Remember that Trump just won an election by blaming the Democrats for inflation. Given that, how will he respond to the inflation his tax, trade and immigration policies create?

Trump genuinely hates trade deficits, and believes tariffs will close them while doing little damage elsewhere. On the campaign trail he said he will place up to a 20 per cent tariff on all imports, and slap China with tariffs of up to 60 per cent. How will they be enacted, exactly?

Having higher trade barriers might be a pure political statement. But some in his circle — including his former trade advisor Peter Navarro — have suggested enacting tariffs would be a negotiating tactic. If that were the case, Navarro points out in the Project 2025 conservative policy playbook, that there are then two potential scenarios: other countries lower their trade barriers, or they raise tariffs in retaliation. The market seems to favour the second scenario, which is clearly inflationary. What if the first plays out?

On the China tariffs, it is unclear if there will be exemptions for products on which the US does not hope to be competitive with China (past exclusions range from X-ray machines to crabmeat), or on which US consumers would feel the pain directly. Unhedged is confident Trump will chicken out before raising the price of iPhones by 60 per cent.

The other major contributor to the higher rates consensus is immigration. As we have written, arrivals have helped keep a lid on inflation recently by slowing wage growth. Trump has promised to effectively close the southern border. This would lead to wage inflation among workers already in the country. That’s part of the point. But the surge in migrants has started to abate, and the US economy is not running as hot as in 2022.

Trump has also said he will deport undocumented immigrants who are already here. VP-elect JD Vance put the number at 1mn people a year. Again, wage inflation is the point of the exercise. But how do you move a million people out of the country? We believe he will give mass deportations a shot. But there will almost certainly be legal challenges and ugly, violent scenes. How strong is Trump’s stomach? How strong is America’s?

One Good Read

In some lighter news, Moo Two

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