Trump's Potential Economic Impact: A Look Back at 2016 and the Current Risks

Remembering 2016

As someone who was sitting on a major North American bank trading floor well into the early hours for the 2016 election, trading a portfolio of non-linear currency risk, it’s easy to recall the market volatility that night. Polls had predicted a slim but overwhelmingly likely win for Hillary Clinton, but when Trump’s victory became apparent, it mirrored the shock of the Brexit vote a few months earlier.  The USD initially sold off heavily as the market considered the rejection of the established political powers to be a negative for the US, and it took a few hours and a conciliatory acceptance speech from Trump before the market reversed. The following months saw the USD rise, US bonds fall (yields rise), and stocks and gold climb, driven by anticipation of Trump’s pro-business, lower-tax and protectionist policies that ushered in a theme of US exceptionalism.

The current backdrop

Trump is once again offering a similar package of promises. Despite his 2016 promise to get rid of the entire national debt in 8 years – a clearly impossible goal – here is what his platform includes this time around (sources: BBC, CNBC):

• Lower taxes
• Less regulation
• Replace Federal Reserve Chairman Jerome Powell / pressure the Federal Reserve to cut interest rates
• Seal the US border / large scale deportation
• Reduce mutual protection with NATO countries that don’t pay their bills
• Implement a universal tariff on all US imports / higher targeted tariff on imports from China
• Encourage domestic energy production
• Centralize power in a variety of ways, e.g., replace civil servants with party loyalists

While there is some mix of inflationary and deflationary policies in the above, Trump’s package of policies has been criticized as inflationary. Sixteen Nobel Prize-winning economists signed a letter warning that Trump would “reignite inflation with his fiscally irresponsible budgets”, which would in turn have a “destabilizing effect on the US domestic currency”.  There are also reports that Trump’s team may be considering a US dollar devaluation, though this remains uncertain.

Comparing to 2016

How do we make sense of Trump’s inflationary policies, but protectionist preference for lower interest rates and a weaker USD?  How does this compare to 2016?

The first difference with 2016 is the polls. Current polls favor Trump to win the election. If this trend holds, the market is unlikely to experience the same level of surprise and volatility as it did in 2016.

A dangerous tail risk

In theory, high inflation is bad for a currency’s value, but in practice, high inflation reports almost always cause a currency’s value to rise. This is because a credible central bank is expected to increase interest rates in response to higher inflation reports, which both reduces inflation that is harmful to the currency’s value, and increases real interest rates, supporting the currency’s value.  If the market doesn’t believe the central bank will act accordingly, unaddressed inflation can have a devastating negative effect on currency values.

Trump’s stance on the Federal Reserve’s independence is concerning at best, and potentially problematic. Trump criticized Chairman Powell during his first presidency, favoring lower interest rates and a weaker USD to help in his trade conflicts with China, undermining central bank independence. Trump has stated he would replace Powell as Fed Chair if elected again, accusing him of politically motivated interest rate cuts in 2024 to help the Democratic Party – a very serious accusation.

Further reports from The Wall Street Journal and Bloomberg suggest Trump’s camp may seek presidential control over interest rates or a USD devaluation, which would be dangerously inflationary  amid the Federal Reserve’s battle to get sticky US inflation back to the 2% target. This approach represents a large negative tail risk to the value of the USD. If true, Trump’s understanding of macroeconomics mirrors Turkish President Recep Tayyip Erdogan, who unconventionally believes that higher interest rates cause inflation. Erdogan’s pressure on the Turkish Central Bank to lower interest rates has led to severe inflation (running as high as 85%) and domestic currency crisis (losing over 75% of its value against the USD) since 2021. This is a cautionary tale for the US and a significant risk for investors.

Putting it all together

Trump's actions can be unpredictable, and his policies might lead to increased inflation, resulting in a stronger USD and higher US yields, albeit with less volatility than in 2016. However, his approach towards the Federal Reserve's independence could present significant risks. This could erode confidence and drastically devalue the USD, potentially upsetting the current world order. Investors would be well advised to monitor this closely.