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The end of the Trump rally?

I generally don’t think I can beat the market, however, right now there is something, which worries me and that is that the “Trump rally” in the US stock market could be about to end.

It seems to me that what US stock market investors are really focusing on is the potential for deregulation and tax cuts (and infrastructure investments). And we might of course get that and deregulation and tax cuts and certainly should be welcomed news both for the US economy and the US stock markets.

But if you get supply side reforms then it will be because of the Republican majority in the House and the Senate (might) want this – not because of Trump. Trump continues to pay lip service to these ideas, but he has certainly not be consistent. There is nothing in Trump’s past that tell us that he is a “free market guy”.

Where he has been consistent – even very consistent – is on his protectionist message and his China bashing. Presently the markets are ignoring this and that might not be the wrong thing to do, but I must say Trump’s 35% tariff talk scares scares me a lot and so does his persistent attempt to “pick a fight” with China.

Another factor, which could spell the end of the “Trump rally” is that not only will the Federal Reserve hike interest rates next week, but the FOMC could also send a more hawkish signal than presently being priced by the market.

In this regard I would particularly focus on inflation expectations, which essentially have stopped rising since 5-year/5-year breakeven inflation expectations broke above 2% a couple of weeks ago. Meanwhile the US stock markets generally has continued to trade (moderately) higher. To me that there seems to be a bit of a disconnect.

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Hence, investors expected some Trumpflation as long as (medium-term) inflation expectation, where below 2%, but from here on investors are likely to increasingly think that there will be full monetary offset of any “fiscal stimulus” from the Trump administration.

So did I just say that the “Trump rally” might soon come to an end? I don’t know and I am not giving investment advice here, but…

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The Trump-Yellen policy mix is the perfect excuse for Trump’s protectionism

It is hard to find any good economic arguments for protectionism. Economists have known this at least since Adam Smith wrote the Wealth of Nations in 1776. That, however, has not stopped president-elect Donald Trump putting forward his protectionist agenda.

At the core of Trump’s protectionist thinking is the idea that trade is essentially a zero sum game. Contrary to conventional economic thinking, which sees trade as mutual beneficial Trump talks about trade in terms of winners and losers. This means that Trump essentially has a Mercantilist ideology, where the wealth of a nation can be measured on how much the country exports relative to its imports.

Therefore, we should expect the Trump administration to pay particularly attention to the US trade deficit and if the trade deficit grows Trump is likely to blame countries like Mexico and China for that.

The Yellen-Trump policy mix will cause the trade deficit to balloon

The paradox is that Trump’s own policies – particularly the announced major tax cuts and large government infrastructure investments – combined with the Federal Reserve’s likely response to the fiscal expansion (higher interest rates) in itself is likely to cause the US trade deficit to balloon.

Hence, a fiscal expansion will cause domestic demand to pick up, which in turn will increase imports. Furthermore, we have already seen the dollar rally on the back of the election Donald Trump as markets are pricing in more aggressive interest rate hikes from the Federal Reserve to curb the “Trumpflationary” pressures.

The strengthening of the dollar will further erode US competitiveness and further add to the worsening the US trade balance.

Add to that, that the strengthen of the dollar and the fears of US protectionist policies already have caused most Emerging Markets currencies – including the Chinese renminbi and the Mexican peso – to weaken against the US dollar.

The perfect excuse

Donald Trump has already said he wants the US Treasury Department to brand China a currency manipulator because he believes that China is keeping the renminbi artificial weak against the dollar to gain an “unfair” trade advantage against the US.

And soon he will have the “evidence” – the US trade deficit is ballooning, Chinese exports to the US are picking up steam and the renminbi continues to weaken. However, any economist would of course know that, that is not a result of China’s currency policies, but rather a direct consequence of Trumponomics more specifically the planed fiscal expansion, but Trump is unlikely to listen to that.

There is a clear echo from the 1980s here. Reagan’s tax cuts and the increase in military spending also caused a ‘double deficit’ – a larger budget deficit and a ballooning trade deficit and even though Reagan was certainly not a protectionist in the same way as Trump is he nonetheless bowed to domestic political pressures and to the pressures American exporters and during his time in offices and numerous import quotas and tariffs were implemented mainly to curb US imports from Japan. Unfortunately, it looks like Trump is very eager to copies these failed policies.

Finally, it should be noted that in 1985 we got the so-called Plaza Accord, which essentially forced the Japanese to allow the yen to strengthen dramatically (and the dollar to weaken). The Plaza Accord undoubtedly was a contributing factor to Japan’s deflationary crisis, which essentially have lasted to this day. One can only fear that a new Plaza Accord, which will strengthen the renminbi and cause the Chinese economy to fall into crisis is Trump’s wet dream.

 

Lessons for today: The conflict between Reagan and Volcker

This is from the The New York Times on February 17 1982:

President Reagan and the chairman of the Federal Reserve Board, Paul A. Volcker, met Monday to discuss monetary and budget policy, Administration officals confirmed today…

… The official said that the meeting covered a broad range of economic issues, including monetary policy and budget deficits. But, the official said, the main reason for the session was to reinforce the ”personal relationship” between the two men. The two last met in December.

The meeting comes after recent tension between the Fed and the Administration, highlighted by the Administration’s contention that the Fed’s erratic management of the money supply was pushing up interest rates and Mr. Volcker’s response that it is the threat of large budget deficits that is affecting interest rates.

…Many economists outside the Government say that the Fed and the Administration are on a collision course on economic policy because the tight monetary policy promised by the Fed will not allow for the relatively strong economic growth the President has forecast will begin by the second half of this year.

Mr. Volcker in an interview Sunday said that he did not think the economy would come ”roaring” back, as Treasury Secretary Donald T. Regan predicted recently. In testimony last week before Congress, the Fed chairman also said he would not count on the Administration’s forecast of relatively strong economic growth for 1983.

…In response to questions about his meetings with the President, Mr. Volcker, in testimony last week, asserted his and the Fed’s independence over monetary policy. ”It is our responsibility to make up our minds about these things, and we do so. Forget about what the Administration says at the moment.”

Paul Volcker was no Arthur Burns and Reagan was no Nixon. In the case of Nixon/Burns Burns just did what Nixon demanded, while Volcker would not back down, but nonetheless avoided all out “war” between the Reagan administration and the Fed and Reagan understood that it was the right thing to do was to (mostly) respect the Federal Reserve’s independence. That said, the policy mix was very bad during Reagan’s two terms as president.

How will story play out between Yellen and Trump in 2017-18?

Donald Trump will replace Janet Yellen with a DOVE in 2018

Some have suggested that when Janet Yellen’s term as Federal Reserve chair expires in 2018 then Donald Trump will try to replace her with a more “hawkish” chairman. Some even has suggested that he could try to re-introduce the gold standard and appoint the king of monetary policy rules John Taylor as new Fed chairman.

I, however, believe that is completely wrong. Donald Trump doesn’t care about the Gold Standard (luckily) and certainly he does not care about a rule-based monetary policy.

The fact is that Trump’s entire policy agenda is inflationary. On the supply side his anti-immigration stance will push up US labour cost and this protectionist agenda will push up import prices.

On the demand side his call for underfunded tax cuts and massive government infrastructure investments also increase inflationary pressures.

So if unchecked (should write un-offset by the Fed?) Trump’s economic policy agenda will push inflation up. However, Trump does not – yet – control monetary policy and if the Federal Reserve is serious about it’s 2% inflation target it sooner or later will have to offset the Trumpflationary policies by hiking interest rates potentially aggressively and allow the dollar to strengthen significantly.

I have argued (see here and here) that initially the Federal Reserve will welcome a “fiscal boost” to support aggregate demand as the Fed for some odd reason is not willing to use monetary policy to hit the 2% inflation target. However, the alliance between the Trump administration and the Federal Reserve could be short-lived if inflation expectations really start to take off.

So in a situation where the Fed moves to hike interest rates more aggressively – for example in the second half of 2017 or in early 2018 it will become clear even to Trump that the Fed is “undermining” his promise of doubling US growth and “create millions of jobs”.

That could very well create a conflict between the Fed and the Trump administration and it is very likely that Trump will accuse Yellen of have too tight a monetary policy. Furthermore, with mid-term elections due in 2018 the Republicans in the Senate and the House are unlikely to be cheering for a “growth killing” tightening of monetary policy.

As I have repeated on the social media over the last couple days – the GOP is (deflationary) “Austrians” when they are in opposition and (inflationary) “Keynesians” when they are in power – they never really favour monetarist and rule-based policies.

After all it was Richard Nixon who famously said “we are all keynesians now” – or rather this is how Milton Friedman interpreted what Nixon said.

Nixon of course had the utterly failed Fed chair Arthur Burns (see more on Burns and Nixon here) to do the dirty work of easing monetary policy when monetary policy already was far too easing.

If Trump reminds me of any US president it is Nixon. So why should we believe Trump would replace Janet Yellen with John Taylor when he can find his own Arthur Burns to help him support his agenda with overly easy monetary policy ahead of the 2020 presidential elections?

If this hypothesis just has a small probability of being right then the market certainly is right is to price in higher inflation during a Trump presidency. I certainly hope I am totally wrong.

PS for a discussion of Nixon and Burns’ relationship seen Burton Abrams very good (and scary) paper How Richard Nixon Pressured Arthur Burns: Evidence From the Nixon Tapes.

PPS Paul Krugman once called for Ben Bernanke to show up for a FOMC press conference in a Hawaii shirt to signal that he would be “irresponsible” and thereby push inflation expectations up and lift interest rates from the ZLB. Maybe Trump is that Hawaiian shirt.

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