Don’t Fight The Fed(eral Government)
Over the past month, the S&P 500 has seen a roughly 10% peak to trough decline. This decline has been driven by President Trump’s trade wars, fears of slowing U.S economic growth, rotation to oversee capital markets, The Yen Carry Trade unwind and cuts to U.S government spending. The decline in the U.S market was not surprising given the rich valuations it currently trades at, however what has been surprising is the Trump administration’s reaction to the sell off.
In Trump 1.0, the U.S. stock market was often touted as a barometer of success. President Trump would consistently point towards the success of asset prices on Twitter to demonstrate the success of the administration’s policies. As part of his obsession with the markets, President Trump would also routinely attack the decisions of the Fed concerning interest rates. Many believed that this obsession with markets and attacks on the Fed would continue under Trump 2.0. However in the first few months, the administration has been notably dismissive of the market downturn. Trump and Treasury Secretary Scott Bessent have been clear in their messaging, the Federal Government is going to reduce their spending, and increase revenue to pay down debt which may cause short term harm in the economy and capital markets.
It is no secret that the government debt is an issue and many in the finance world have pointed out the $9 TRILLION of debt that will need to be refinanced this year. Obviously, refinancing this debt at 2 or 3% rather than 4% saves the United States billions of dollars of interest expense each year. Market participants seem to believe that Trump’s lack of comments toward the market, and his apparently random tariff discussions are intentional, as a means to tank the economy and force the Federal Reserve to lower interest rates.
We will work under the assumption that President Trump’s main objective is to lower interest rates through the methods described above. Below, we will detail out the potential risks the administration faces executing their apparent plan. We will also detail out other macroeconomic risks that may be playing into the market downturn
One of the major risks the Trump Administration faces is the risk that even if the Federal Reserve cuts rates, the interest rate that is demanded to buy the 10 year Treasury stays elevated. Currently, the global debt market may become saturated as tariff discussions in the United States have triggered a wave of isolationism in other countries. For example, the German government has made it clear that they plan to invest over $1 trillion in the coming years increasing their deficit past the 2% mark. China has also been running deficits in order to stimulate its economy and stay on target of 5% growth. As more countries plan to spend, the global debt market will become saturated with supply forcing the bond yields higher, essentially negating the Fed rate cut.
Touching more on the isolationism that we have seen, there are two major risks that we may already be dealing with some of the effects of in markets. First, the unwind of the Japanese carry trade may be the reason that the Mag 7 is underperforming the broad market even though they are largely unaffected by tariffs. The Bank of Japan has kept interest rates at or below 0% for years as they tried to stimulate growth in the Japanese economy. These low interest rates, combined with a weak currency relative to the Dollar has made it easy for individuals to borrow in Yen and subsequently invest in United States assets, namely the Mag 7 stocks. However, with the Japanese economy facing 4% inflation and the Bank of Japan starting to raise interest rates, those investors that borrowed in Yen are having to sell their US stock holdings to cover the rising cost of capital. Many believed that the Yen carry trade was flushed out in August 2024 with the spike in volatility, however we may be seeing a second round of deleveraging.
Changing international investment in the US stock market is also one of the risks that the market may face in the coming months. With the “America First Investment Policy” President Trump signals that China may face a more difficult challenge when investing in US Markets. This is significant because China has not been buying bonds with their trade surplus, but rather they have been investing in the US markets. Although it seems that President Trump is attempting to fill that investment gap with other nations such as the UAE, it may be hard to fill as China runs an annual trade surplus of almost $1 Trillion per year.
Over the coming months, it seems that tariffs, isolationism and economic growth forecasts will continue to drive the market. It also remains to be seen what tariffs the market has priced in for April 2nd and what tariffs will come as a surprise to markets. With the AI trade fading, there may be a lack of positive catalysts in the coming months to drive markets higher. Once again the markets may be in the hands of the Fed as interest rates seem to be in full focus for the Trump administration.
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