What do the markets think of the new world order under Donald Trump? At the end of a tumultuous week in which markets behaved like headless chickens most of the time, we can now discern the broad outlines of what the new regime may look like.
The old global market paradigm was based on the assumption that interest rates in the developed markets would remain very low for the foreseeable future. That narrative has changed dramatically. The story now is that Trump will allow the US fiscal deficit to bloat while he splurges on infrastructure. That will raise inflation and interest rates in the US. Also, Trump will be more protectionist, which too will raise inflation.
So why are US equity markets, which till the other day threw a tantrum at the mere whiff of higher interest rates, partying hard? They think that public spending will boost the US economy, in spite of rising interest rates. Hence the rise in US stocks, which also got a leg-up from Trump’s promises of a sizable tax cut and business deregulation. Bonds, on the other hand, were decimated. Chart 1 maps the Bloomberg US Treasury Bond Index versus the Dow Jones Industrials last week. The former plunged, while US stocks made new highs.
Chart 2 shows the other big trend in the equity markets last week—plummeting emerging market stocks. Emerging market bonds too were hammered. The expected rise in US interest rates led to money being pulled back from carry trades, seen in the steep rise in the Japanese yen. Trump’s protectionist views on international trade could also hurt emerging markets.
The rise in US yields led to a stronger dollar and emerging market currencies weakened. Chart 3 shows the MSCI Emerging Markets Currency Index fell sharply last week, in spite of central bank intervention.
If Trump pushes infrastructure spending in the US, that will give an added push to demand for industrial metals, the prices of which have already zoomed, thanks to supply curbs and a spending revival in China. Chart 4, the Bloomberg Industrial Metals Subindex, shows how metal prices went up last week.
Of course, these trends assume that Trump will do what he promised. He has often gone back on his word, so the uncertainty will continue. It is entirely possible he may want to keep interest rates low to fuel US growth, in addition to giving a fiscal stimulus. On the other hand, it’s by no means certain that fiscal conservatives in Congress will give him a free hand on the deficit or that such spending will be substantial.
Also, it won’t be a one-way street—for instance, given negative interest rates in Europe, European investors would flock to buy US bonds which now yield a much better return, driving down US yields. After all, global deflation hasn’t been beaten yet and Fed Funds Futures point to only one 25 basis point rise in the next six months. But the fact remains that the US 10-year bond yield, despite its sharp rise in the past week, is still lower than where it was at the beginning of the year and well below its highs in early 2014, suggesting any policy shift is yet to be priced in.
Finally, if Trump is silly enough to carry out some of his more extreme proposals, that could lead to a global recession or worse. Let’s also not forget that Trump’s victory may have a domino effect, especially in Europe. The next challenge to the established order is the Italian referendum on 4 December.