Daily Comment (January 23, 2017)

by Bill O’Grady, Kaisa Stucke, and Thomas Wash

[Posted: 9:30 AM EST] It was a rather tumultuous weekend with the incoming administration sparring with the media over a number of issues.  Those factors are being hashed out in the media so we won’t focus on them.  However, what we are paying attention to is the impact on financial markets.  The dollar is sharply lower this morning; some of this weakness is probably due to the fact that there was so little in the weekend comments from the new government on trade and tax policy.  The inaugural speech was clear that the U.S. will be adjusting its superpower role, something we discussed in the 2017 Geopolitical Outlook under the idea that the U.S. is shifting from a mostly benevolent hegemon to a malevolent superpower.  The speech puts the world on notice that U.S. foreign policy will be about boosting U.S. growth even at the potential expense of foreign growth and stability.

This, by itself, is a major shift in U.S. policy.  It essentially marks the end of how the U.S. has managed the world since 1944.  Although American policy has been successful (the primary goal was to prevent WWIII, which we did accomplish), it hasn’t been cheap.  The U.S. has been forced to increase the size of government (there is no such thing as a small government superpower), expand domestic and foreign surveillance (the U.S. had one intelligence agency at the end of WWII; now, 17), suffer through a series of status quo wars and run persistent trade deficits to ensure adequate global dollar liquidity.  These costs were significant and the burdens were not equally distributed.  Trump’s broad policy, it seems, is to lower these costs and redistribute the burden.

It’s the actual policy measures that are unknown.  We note that this morning the U.S. formally exited TPP; TTIP is also essentially dead, meaning the U.S. won’t be the global pivot for trade rules.  Greg Ip had a report in the WSJ over the weekend suggesting that Trump doesn’t want a broad-based tariff.  Instead, he wants to be able to wield the threat of trade restrictions to encourage foreign firms to build plants and equipment in the U.S. and, at the same time, discourage U.S. firms from doing the same abroad.[1]  That may mean he will reject the Ryan corporate tax reform that includes border adjustments.  These adjustments will reduce the president’s power to affect investment changes.  Instead, Trump has been calling for a large cut in corporate tax rates.  Interestingly enough, without the border tax adjustment, the tax cuts will likely lead to lower government tax revenue.  Trump seems to be signaling a general disregard for deficits.[2]

This leads us to this morning’s market action.  Is the weaker dollar a sign that investors are concluding that Trump’s policies won’t be as dollar bullish as originally thought or is this mere profit-taking (“buy on the election, sell at inauguration”)?  We suspect it is more the latter.  Trump’s policies appear to be reflationary; in other words, he wants to pump up nominal GDP growth.  Under normal circumstances, that should lead to dollar strength as rising nominal growth usually leads to higher interest rates.  For now, we are assuming that the Fed will raise rates faster if inflation rises quicker than expected.

However, that thesis assumes the FOMC will react to higher inflation by tightening monetary policy.  We would not be surprised to see President Trump try to cajole the Fed into maintaining steady rates when faced with rising inflation.  Most of us have spent our careers during a period of central bank independence and support for inflation control.  However, that hasn’t always been the conduct of policy.  Under Fed Chairs Arthur Burns and William Miller, the Nixon and Carter administrations (especially the former) pressed the Fed to maintain easy money in the face of rising inflation.  Carter did reverse that policy with the appointment of Paul Volcker; we note that Carter was a one-term president.  Simply put, we would not be completely shocked to see Trump appoint doves to the two open governor positions and press the Fed to keep rates low despite rising inflation and wages.  If that is the outcome, we are looking at a dollar bear market.  For now, we don’t think this is the most likely outcome but it is one we are watching closely.

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[1] http://www.wsj.com/articles/trump-on-trade-peace-through-strength-1485086400 (paywall)

[2] This is generally not unique; the party that holds the White House tends to be less concerned with deficits and becomes fiscally hawkish when out of power.