Thinking About Trump, the Fed and the Markets

The markets are repricing as they absorb the implications of Trump's victory.   For stocks and oil, the repricing is sectoral as well as macroeconomic in nature.   For Treasuries, the backup in yields reflects a greater risk of aggressive fiscal policy and stronger economic growth/inflation ahead.  There is unlikely to be any significant unwinding of these market moves before he takes office in January.  Even weaker economic data should have limited impact, given prospects of large tax cuts and infrastructure outlays ahead. 

But, once Trump gets into office and fleshes out his policies, the markets could act quite differently.   In broad terms, the biggest threat to the economy would likely be a trade war resulting from his desire to protect US jobs.  In contrast, the biggest boon to the economy could be the combination of large fiscal stimulus and a cautious Fed.  Here are a couple of scenarios.

Negative for Stocks, Positive for Treasuries
1.  Trump's approach to help sustain US jobs in a global economy -- one of his main campaign promises -- could lead to a trade war if he goes with pushing for large tariffs.  A trade war would raise prospects of a global recession.  Obviously, the US job situation would worsen in this case.

2.  The risk of large tariffs cannot be dismissed.

      a.  Policy approaches short of large tariffs probably would not save US jobs.  Even if companies are "persuaded" to keep factories running in the US, they would be undermined by competitive pressures from non-US companies operating in low-cost countries. 

       b.  One idea -- although no one has mentioned it -- is to use tax policy to lower labor costs.   For example, corporate taxes could be cut by at least doubling the deduction for labor costs.  This would be an alternative to a cut in corporate tax rates.  This would go only part way to preserving jobs, however, since the wage differential between the US and other countries is probably too large to be offset this way.  Also, the tax subsidy could increase demand for labor and result in a bidding up of wages -- offsetting the tax subsidy  And, the dollar could strengthen, making imports cheaper.

Positive for Stocks, Negative for Treasuries
1.  With so much uncertainty about how the Trump administration will proceed to implement its policies, a cautious Fed monetary policy would be reasonable.  And, at least one Fed official has said that the Fed will wait for awhile to hike again if it does so in December. 

       a.   Recent US economic data have not been strong enough to hold back the Fed from a December hike, but this week's October CPI release could be important if it is soft.

       b.  If the Fed hikes, its forward guidance -- either as shown in the "dots" or in Yellen's post-meeting press conference -- will be more important.

2.  A slow pace of Fed tightening along with fiscal stimulus would fit with Yellen's speculation about the desirability of "running a high-pressure" economy."  Her idea is that this could spur higher productivity growth.  The Fed could delay further tightening until H217 in this scenario.

3.  The boost to economic growth could be less than expected, however, as a result of higher longer-term Treasury yields, a stronger dollar, and the spillover to imports.