Trump Trade's Demise Sends A Clear Negative Message
The euphoria in markets following Donald Trump's U.S. presidential election victory that came to be known as the Trump trade is stumbling. Last week's decision by Trump to pull out of the Paris climate accord bolstered the perception that the U.S. may be become a more isolated player on the world stage, negatively affecting the dollar. The market for U.S. Treasuries is taking note of these developments amid signs that the economy is having trouble gaining steam, as evidenced by a precipitous flattening of the yield curve. Yet, the S&P 500 Index remains upbeat on the hope of tax reform and deregulation.
Within these market dynamics there is a message that is driving the Trump trade in different directions. This message has several implications for the economy, Federal Reserve monetary policy and equity returns.
The Trump Trade Moves in Different Directions
The first message is that the risk of an economic slowdown is building. That can be seen in the current low levels of market volatility, which in the past has been a precursor to periods of sluggish to negative growth. A weakening dollar and reduced expectations for the implementation of Trump's pro-growth policies has helped volatility drop to unusually low levels at a time when more investors are moving to the sidelines and the savings rate among consumers rises to its highest level since the election in early November.
Although an immediate recession seems remote, there is historical precedent for uncertainty about tax reform impacting the economy adversely. During Ronald Reagan's presidency in the early 1980s the U.S. economy fell back into recession because tax reform took several years to be completed. The message from the directional change in the Trump trade is that a similar experience isn't out of the question. That would have consequences for Fed policy and interest rates.
U.S. GDP and VIX
Despite the recent subdued readings on inflation, Fed officials have provided extensive guidance about their plan to shrink the central bank's $4.46 trillion balance sheet as part of its normalization of monetary policy. The process would take place over the course of three to five years at a gradual pace of $400 billion per annum with the amount of excess reserves in the banking system reduced to $300 billion. Although the take-it-slow approach may comfort the markets and suppress interest-rate volatility, a change in reserves would remove one of “safest” assets from the global financial system. Those assets should be replaced by other safe assets, with the prime substitute being U.S. Treasuries. As such, the Treasury yield curve may flatten to a near “inversion” levels, leading to a lengthier pause in Fed policy normalization despite low levels of unemployment.
Source: Bloomberg, Bank of International Settlements
The stock market has had a good run but the downward momentum in the dollar, Treasury yields and volatility suggests a false sense of optimism in equities. Although a weaker dollar can be positive for corporate earnings and lower rates can be favorable for corporate borrowing, equity risk premiums remain wide because of the uncertainty expressed by low bond yields and negative term premiums. That is a conflicted message because it shows both high expectations of earnings growth as well as concern of an impending economic slowdown. Any shift in volatility driven by the notion that the economy is losing momentum is likely to reverse the direction of the Trump trade by realigning equities with a lower dollar and bond yields.
Equity and Bond Risk Premiums
Source: Bloomberg, Federal Reserve. Term premium taken from Fed Kim-Wright Model.
The Trump trade had a positive effect on markets, but the recent directional change has a darker message for what lies ahead. Investors should remain cautious and “play defense,” which by itself is likely to take further steam out of the Trump trade.
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