Markets have rushed to conclude that the Trump administration will unshackle developed world economies from the secular growth stagnation that has depressed equilibrium interest rates and bond yields since the financial crisis. But expansionary fiscal and protectionist trade policies won’t impact growth in a vacuum; their knock on effect on inflation, and thus monetary policy and bond yields, will dictate the ultimate pass through to final aggregate demand in the economy. How will the FOMC shape monetary policy in an environment where visibility on current economic momentum is constructive, but uncertainty around the sequencing and ultimate economic impact of Trump’s policy mix clouds the forecast horizon? The balance of risks in the Treasury market has shifted. Prior to the election, Treasury investors under-estimated the potential for any pro-growth impulse from fiscal policy over the coming year, but the recent reset in yields acknowledges the possibility that instead of continually revising its rate forecast lower for longer, Trump’s policies may force the Fed to transition to move rates higher, sooner.
A tight labor market is reviving aggregate wage growth. Even the least skilled workers are getting a raise as the pool of unemployed, low-skilled workers has largely evaporated. The unemployment rate for those aged 25 and over without a high school diploma has halved from nearly 16% in 2010 to just under 8% now, such that this group is experiencing the strongest rise in real median weekly earnings now. To be sure, however, this cohort still has a long way to go to make up for lost earning power, having experienced a cumulative -22% decline in real median wages since 1980, the largest loss of all the labor force constituencies if grouped by educational attainment. No wonder this group voted for Trump’s promise to Make America Great Again. A quote embodying the definition of populism is particularly apt in this context: “I equate the person who vibrantly describes my rage with the person who has the solution to my rage.”
The effectiveness of any fiscal expansion program depends critically on how fully the growth transmission mechanism or fiscal multiplier works. These multipliers can vary widely. The Congressional budget office estimates that large income tax cuts for high income earners or corporate tax relief won’t do much for growth and thus the uneducated factory worker, whereas direct spending by government on outlays such as infrastructure, tends to have a much higher multiplier. Fiscal stimulus can be cumulatively triply stimulative for growth when the economy is operating below potential, versus when it’s operating at potential, because slack usually precludes the need for monetary offset. In an environment where the economy already has momentum, the net fiscal multiplier may be limited, if monetary policymakers respond to the increase in demand from government stimulus by hiking rates more aggressively than they would otherwise.
Emerging Asian economies have benefited the most from 35 years of globalization. Exports have driven a rise in living standards, as measured by per capita gdp growth. We expect Asian currencies to suffer disproportionately from this new round of dollar strength, as Trump’s trade retribution hits these countries the hardest. Compared to the drubbing Latam currencies have endured since the peak in resource prices in 2011, the KRW, TWD, and SGD are only trading 13%, 9%, and 15% below their post 2010 highs. An appreciating dollar can hurt emerging markets in three ways. First, a stronger dollar can weigh on commodity prices. Second, it can punish emerging market borrowers with significant dollar liabilities. Third, Fed rate hikes are liable to reduce global dollar liquidity, making it difficult for a number of emerging economies to attract enough foreign capital to finance their current account deficits.
The US yield curve has been under relentless flattening pressure over the last 6 years as markets have doubted the durability of the US business expansion amid numerous negative shocks. The yield curve will be a barometer for how much growth candidate Trump delivers as President Trump. The more stimulus is financed by debt, the more Treasuries will be issued and interest will owed, the higher inflation will climb, and the steeper the curve will get. Right now the Fed telegraphs a rate hike in December of this year, and two more hikes in 2017. The Fed will likely want to avoid a rerun of last December’s market riot by offering too much hawkish guidance about next year without visibility on what form Trump’s economic policies are likely to take.