Where there was discord, Donald Trump has remarkably brought harmony. He has brought peace between the markets and Janet Yellen, as traders at last appear to believe her forecast for interest rates over the next year.
The Federal Reserve says it intends to raise rates three times next year, and the market implicitly, through Fed Funds futures, puts the chance of this happening at almost exactly 50 per cent. This follows five years of the Fed’s current attempt at transparency in which markets have persistently and successfully bet that rates will stay stuck near zero, whatever Ms Yellen may tell them.
It is the sharp change in psychology that came with Mr Trump’s election victory that has at last brought the rate markets and the central bank in tune with each other.
The problem is that the newfound belief in a hawkish Fed scares the bond and foreign exchange markets rigid. Ms Yellen perhaps inadvertently fed this in her press conference by commenting that fiscal policy was not really needed now — a very direct contradiction to the stance of the new administration. The strong language she used about the strength of the US economy and labour market also gave the impression that she was prepared to be even more hawkish in future.
The reaction to Ms Yellen’s press conference was almost certainly exaggerated and greater than she wanted, and some attempt by the Fed to talk traders back from the precipice over the next few days is likely. But the market reaction does indicate that the fixed income market is indeed prone to an overdramatic sell-off. Fears of this were not overdone, and this is unwelcome news.
For the time being, Ms Yellen’s undiplomatic efforts will render her unpopular with Mr Trump. The consolation may be that they now find themselves facing the same serious and urgent problem; dollar strength. By the end of Wednesday’s hectic trading, the dollar had hit its highest on a trade-weighted basis since early 2003, before the invasion of Iraq.
The economic and financial logic is ineffable. If the US is genuinely going to reflate, then interest rates will need to rise. That will attract funds to the dollar, particularly from economies like Japan and Germany where rates are still on the floor. Yield differentials are now extreme. The spread of 10-year Treasury yields over equivalent German Bunds is now its widest since the spring of 1989, before German reunification.
This should be helpful for Japan and Germany, export-oriented economies. It is extremely unhelpful for China, still tied to the dollar, and for many emerging markets, where dollar strength — as shown during 2013’s “taper tantrum” — can easily translate into crisis conditions. It is unhelpful for Ms Yellen, as a strong dollar tamps down inflation, through its effect on import prices, as well as growth.
It is also deeply unhelpful to Mr Trump. His signature aim is to restore US manufacturing and to defend the country’s trade position. A dollar this strong has much the same effect as an array of protective tariffs against US goods.
Further, the Fed’s intended rate trajectory is based on GDP growth that will barely exceed 2 per cent over the next four years. Mr Trump’s clear commitment is to try to get growth up to 3.5 per cent. Fiscal policy generous enough to propel growth that strong would likely entail higher rates, and an even stronger dollar. The alternative would be an irresponsible Fed that was prepared to run the risk of allowing inflation to take off once more.
Ultimately, the quandary for Mr Trump and Ms Yellen is identical and uncomfortable. There are limits to how much globalisation can be peeled back. Financial markets in a global setting put limits on how far the US can restimulate its own economy.
