Financial Conditions Are Rigged Against Donald Trump

The markets aren't helping to Make America Great Again.

Can the U.S. Risk Rally Last?

The reaction in financial markets to President-elect Donald Trump's election victory — much like the win itself — has defied conventional wisdom, with U.S. equities surging following a sharp drop as the results came in. But if you're an occasional real estate developer — a self-professed "low interest rate guy" who wants to fix America's trade deficit while bringing factories back from overseas — it might seem as though markets have been rigged against you.

The U.S. dollar spot index (DXY) touched levels not seen since the Clinton administration on Friday morning, and the yield on the 10-year U.S. Treasury has increased by more than 50 basis points since Nov. 9. This rise in the greenback and borrowing costs for the U.S. constitutes a tightening of financial conditions — a potential obstacle to U.S. growth, as servicing new debt has become more expensive and goods produced domestically are now less attractive to foreigners. 

DXY Curncy (DOLLAR INDEX SPOT) L 2016-11-18 08-18-15
Source: Bloomberg

Earlier this week, the Goldman Sachs Financial Conditions Index rose above 100 to hit levels not seen since March, when the financial backdrop was trending in a more accommodative direction following the market turmoil that started 2016.

GSERFCI Index (Goldman Sachs Fin 2016-11-18 10-44-03
Source: Bloomberg

The index tracks changes in interest rates, credit spreads, equity prices, and the value of the U.S. dollar: a rise indicates that financial conditions have tightened. "A stronger USD implies lower domestic inflation and higher real rates, a headwind to U.S. growth," writes Neil Dutta, head of U.S. economics at Renaissance Macro Research.

In her testimony before Congress on Thursday, Federal Reserve Chair Janet Yellen highlighted this rise in the U.S. dollar as well as interest rates since the election — but not the gains in the stock market.

This may serve as an implicit nod at what's reflected in many financial conditions indexes: There's a certain degree of asymmetry at play, with the rise in the greenback and U.S. Treasury yields far outweighing the tightening of credit spreads and rise in stock values. That asymmetry perhaps speaks to an unintentional and counterintuitive overlap between how the president-elect and the Federal Reserve interpret how changes in financial conditions affect real economic activity.

To a certain extent, the rise in the greenback and U.S. Treasury yields reflect expectations regarding the future path of the federal funds rate. On the other hand, these market moves have the power to be a self-unfulfilling prophesy.

In the short term, the Federal Reserve might prefer hiking into a steeper curve to avoid the potential negative psychological effect of raising rates while there's a relatively small gap between yields on short-term and longer-dated debt, as recession has often followed a curve inversion. However, this is a central bank has been highly attuned to how shifts in financial conditions and the global growth backdrop influence the domestic outlook.

Earlier this year, Yellen remarked that the dialing down of expectations regarding the aggressiveness of its tightening path in response to market turmoil constituted an "automatic stabilizer" for the economy by way of easing financial conditions.

Fed Governor Lael Brainard, meanwhile, has noted that the central bank's economic models treat a 10 percent rise in the trade-weighted U.S. dollar as roughly equivalent to a 100 basis point increase in the federal funds rate, in terms of the effect on tamping down economic activity stateside.

As such, the recent tightening of financial conditions "keeps the Fed a little easier than implied market path/inflation (which should steepen the yield curve even more)," said Naufal Sanaullah, macro trader and founder of the website MacroBeat.

That could be especially true in the event that the markets become priced for "fiscal policy perfection" under President-elect Trump, which RBC Capital Markets Chief U.S. Economist Tom Porcelli argues hasn't happened yet.

"Although federal funds markets have indeed priced in a bit more tightening on the horizon, the shift between the pre-election curve and the current one amounts to one additional hike between now and the end of 2018," he writes. "Not exactly a screaming reassessment of the growth/inflation backdrop in the near-term. Indeed, the current FF curve remains well below where it stood at this time last year."

FF CURVE
Source: Bloomberg

In the event that fiscal expansion and its subsequent effect on the central bank is more aggressively priced in, this would likely a 'big league' tightening of financial conditions, with the market effectively doing the Fed's work for it — and leaving the rest of the world struggling to cope with the spillover effects.

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