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Has President Trump introduced a Trump Put by lashing out about
rising interest rates and calling for a weaker dollar? The market
reacted swiftly - and rationally - albeit not the way Trump had intended. Let
me explain.
 
Trump suggests the U.S. is put at a “disadvantage” given that the European
Central Bank and Bank of Japan continue their more expansionary monetary
policies. Markets reacted by selling off the dollar versus major currencies.
If that were all, you might shrug this off as disruptor-in-chief rattling the
currency markets a bit. Maybe there isn’t much more to it. After all,
speculators had been bidding up the greenback of late and, possibly, this was
as good a catalyst as any to take some profits.1 But that’s not
the end of it. First, Mr. Trump appears to favor a weaker dollar and may well
provide more verbal intervention should the dollar resume its climb. In that
sense, Mr. Trump has introduced Trump put. But why is it that a comment by
the President moves currency markets? Partially, this may be because he has
shown a willingness to use executive power to interfere with trade.
However, Trump went beyond suggesting the dollar should weaken. In this
interview with CNBC that aired last Friday, President Trump said, “I don’t
like all of this work that we’re putting into the economy and then I see
rates going up.” He qualified his statement saying, “but at the same time I’m
letting them do what they feel is best.”
Yet, as Mr. Trump called for lower borrowing costs for the U.S. in an era
of rising deficits, borrowing costs actually rose. In our assessment, this is
no co-incidence. Here’s why:
- The cheapest form of monetary policy is verbal. If a
central banker tells us “rates will be low for an extended period of
time,” the bond market will reflect this, assuming that comment is
credible.
- If verbal guidance (think “forward guidance”) is
insufficient, the central bank needs to raise or lower rates.
- In times of crises, lowering rates may be insufficient,
and the central bank may need to intervene more heavily in the markets,
such as through large-scale purchases of bonds (so-called quantitative
easing).
As former Treasury Secretary Hank Paulson once said, if you have a
bazooka, you may not need to use it. That is, to prove my point: words are
“cheaper” than action.
Here’s the rub: when politicians start chiming in on monetary policy -
especially if it is someone influential who implies policy makers at the Fed
could be fired (Trump is “letting them”) - it torpedoes monetary policy,
diluting the message of the Fed. As a direct consequence, it is more
expensive for the Fed to pursue whatever plan it has. In my view, that is why
bonds sold off, yields rose: debt that needs to be refinanced will need to be
financed at a higher rate.
To be clear:
- Technically, Trump could fire Powell “for cause”, but I
consider the odds remote.
- I don’t consider Fed Chair Powell a pushover.
Market professionals talk about an ‘increased risk premium’ being priced
into the yield curve. Differently said, the dollar just got ‘riskier’,
explaining why yields rose, even as the dollar fell.
But if Powell is no pushover, does it matter what Trump says in an
interview? Isn’t the Fed independent? In my humble opinion, currencies - and
monetary policy - are a credibility game. Monetary policy is effective
because there’s the general belief the Fed will do the right thing. Anything
that reduces this effectiveness is not desirable. Note that the Fed shares
responsibility for Trump’s comment. How come? Not because the Fed has raised
rates several times and is expected to raise rates further, but because the
Fed’s actions since the financial crisis have invited political interference
as the Fed has stepped onto fiscal turf: The Fed’s buying of Mortgage-Backed
Securities (MBS) is fiscal policy as it allocates money to a specific sector
of the economy. The Fed’s paying of interest on excess reserves (IOER) is
also a political hot potato, as the Fed is literally paying billions to banks
in an effort to discourage banks from lending. Not surprisingly, political
attacks on the Fed have increased.
In the 1970s, political interference contributed to stagflation. In
contrast, in the early 1980s, President Reagan had Fed Chair Volcker’s back
when he raised rates rather substantially. Should we care about either of
these precedents when the economy is doing reasonably well? The economy may
be doing well right now, but consider the following scenario:
- The economy continues to grow at a reasonable pace;
- We are near full employment;
- Wage pressures continue to rise;
- The Fed continues to raise interest rates;
- The economy starts to slow down as higher rates start to
have an impact on growth;
- Wage pressures continue to rise, even as the economy
slows down;
- The Fed continues to raise interest rates
If you look at the chart above, you see inflation is already at the Fed’s
target of 2%; some shrug off recent rises in inflation data due to
statistical aberrations, but an economic stimulus at a time when the economy
runs near full employment may well make it plausible that my scenario is
realistic.
Many pundits may scream “stop” once the yield curve inverts (when
short-term rates exceed long-term rates), but keep in mind the Fed’s mandate
is not to prevent the yield curve from inverting.
Now put Mr. Trump into the mix. You have an economy that shows strains,
yet the Fed continues to raise rates. In such a scenario, I would think it is
perfectly plausible to hear more lashing out at the Fed by the President.
Will the Fed set different interest rates as a result? Even if Mr. Powell is
no pushover, it may be costly nonetheless as Fed policy may have gotten more
expensive: more action (higher rates) may be necessary because of the
political interference than otherwise would be warranted. And there you have
it: a Trump put with unintended consequences.
If you are interested in learning how to take direct positions on interest
rates, we might be able to be of service click here to learn more. In the
meantime, please explore our chartbooks,
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Axel Merk
President & CIO, Merk Investments
(1) Our reading of the July 20 Commitment of Traders (COT) report suggests
speculators had substantial positions betting on a stronger dollar. The
report is released on Fridays based on positions in the futures markets by
investors classified as speculators the preceding Tuesday.
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