Market Brief: Trump Trade Eases, Dollar Retreats

Market momentum is fading this morning after investors speed-ran the “Trump trade” in yesterday’s session. The trade-weighted dollar is retreating after recording its best day in more than two years, with the Canadian dollar, euro, pound, and yen all up roughly half a percentage point while the Mexican peso - widely considered a proxy for US isolationism risks - is trading above pre-election levels. Treasury yields are easing somewhat, North American equity futures are consolidating gains, and oil prices are weakening.

The pound is pushing higher after the Bank of England cut interest rates for a second time but raised its inflation forecasts, helping to ratify a repricing in gilt yields that followed the government’s recent Autumn Budget. Policymakers voted by a 8-to-9 margin to lower the benchmark overnight rate by a quarter point, noting that “based on the evolving evidence, a gradual approach to removing policy restraint remained appropriate”. However, the accompanying Monetary Policy Report suggested that the consumer price index could be half a percentage point higher over the next year as finance minister Rachel Reeves’ plan for a substantial increase in government spending translates into more demand in the economy. Governor Bailey said “We need to make sure inflation stays close to target, so we can’t cut interest rates too quickly or by too much. But if the economy evolves as we expect, it’s likely that interest rates will continue to fall gradually from here.”

The Federal Open Market Committee will almost certainly deliver a quarter-point rate cut this afternoon, but markets are set to focus on the accompanying communications for hints as to how policymakers are viewing recent economic developments. The statement may support a slightly hawkish interpretation, with the language pertaining to labour market conditions adjusted to reflect a stabilisation in unemployment rates and worker demand, but officials are likely to wait till December before providing a clearer signal. According to September’s Summary of Economic Projections, officials have a total of two cuts pencilled in by year end, with another four projected in 2025. This is now at odds with markets, where futures traders expect just four moves over the same period.

Chair Powell will also face questions regarding the impact of Tuesday’s presidential election on the Fed’s policy path and economy. He is likely to give short shrift to the threat of interference from the Oval Office, continuing to emphasise the value in maintaining an independent approach to setting monetary policy, while also - perhaps silently - remaining confident in long-standing structural barriers* to political intervention. We think he will stick to a long-standing preference for avoiding anything resembling forward guidance, instead choosing to describe how the central bank will react to incoming data - and this is a reasonable approach, given that there are major uncertainties surrounding Donald Trump’s policy platform.

Foreign exchange traders appear increasingly convinced that the president-elect will not follow through on his campaign promise to impose a universal tariff on most US trading partners. Currencies most vulnerable to a potential rise in US protectionism—such as the Mexican peso, Canadian dollar, and Chinese yuan—moved less than expected during yesterday's session and are now appreciating against the dollar. This may reflect concerns about the “Mutually Assured Destruction” (MAD) scenario that could unfold if the US were to wage a multi-front trade war against all of its allies simultaneously: while a blanket tariff might harm individual trading partners, the cumulative impact of retaliatory actions could damage the US economy just as severely. Instead, the market seems to be pricing in a more targeted approach, with protectionist actions focused on China and countries with significant transshipment flows.

But Treasury yields are nonetheless pushing higher as investors brace for a more fiscally expansionist regime. The benchmark ten-year yield is holding near 4.43 percent this morning, up from 3.8 percent in September, and talk of “bond vigilantes” - investors who baulk in the face of profligate government borrowing - is dominating conversation about the trillions in additional unfunded spending increases and tax cuts that are expected in coming years. Markets are again focusing on the extent to which “price sensitive” buyers - hedge funds, mutual funds, insurers and pensions - have displaced foreign governments, commercial banks, and the Federal Reserve in absorbing the bulk of Treasury issuance in recent years, and credible observers are suggesting that a break back above the 5-percent threshold is possible if investors grow more wary.

The Republican sweep could therefore have a more profound impact on the global economy through interest rates than through the trade channel. In today’s global financial system, higher US yields translate directly into higher borrowing costs elsewhere, putting strain on economies - like Canada’s - that are highly indebted and reliant on short-term US funding markets. To illustrate: over the decades, Canada’s five-year conventional mortgage rate - which is ultimately driven by rates available in bond markets that have to compete for global capital - has often tended to follow changes in Treasury yields more closely than the Bank of Canada’s policy rate, occasionally even moving in an opposing direction. If US rates continue to climb, the rest of the world will get squeezed.

*I wrote a bunch of nonsense and built a chart to illustrate how the Fed's governance structure shields it from political interference in the short term, but Bloomberg did it far better. Read their analysis here.

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