9 November 16

What does a Trump presidency mean for US interest rates?

What does a Trump presidency mean for interest rates?

By Triple Point Partner, Ian McLennan

On balance, in the short run, say 3 to 6 months, interest rates are likely to remain lower for longer. But over the longer run the picture is different - long term interest rates may rise prompting short term interest rates also to rise more quickly than otherwise would have been the case.

Here is why:

Short-term uncertainty will probably inhibit interest rate rises

In the short run Trump adds more uncertainty to the economic and market outlook than Clinton would have. First, he has no track record as an elected politician - no voting record to look back on as a check on "what he really thinks". Second the ideology he has put forward could be said to be somewhat confusing - he has been elected as a Republican yet he talked as though he is anti-free trade and of boosting infrastructure spending.

To the extent uncertainties create market volatility and business hesitancy the Federal Reserve is likely to delay or soften the programme of interest rate rises that it otherwise seems to be increasingly anxious to pursue.

But in the longer term a reduction in the potential for growth as a result of restrictions on trade and migration, combined with high spending plans on infrastructure could lead to higher rates

First, the output gap is a key measure for setting interest rates

President-elect Trump has taken a clear position against the free trade agreements and immigration patterns of the last 20 years. While the division of the spoils from free trade within economies has certainly been in debate over the last 18 months (including seemingly in the Brexit vote) most economists still believe that freer trade and freer movement of people are a positive for overall economic growth and for the important concept of the economy's potential output.

So-called "output gap economics" says essentially that the bigger the difference between the current size of the economy and its potential output, the bigger is the so-called "output gap" and the lower that interest rates should, or could, be without promoting inflation. When an output gap is present there is little likelihood that the economy will see high inflation and for that reason central banks like the Fed are continually trying to estimate the size of such a gap as a guide to when and how quickly they should raise interest rates.  

If Trump gets his way by pursuing policies that reduce trade and immigration then the U.S. economy's POTENTIAL growth would be smaller than otherwise and so-called neutral interest rates should be higher than otherwise. Now it may be that the Republicans in Congress will at some point block Trump's trade agenda, but they are less likely to stop him enacting some changes on immigration.  In practice that would mean the Fed would at some point have to raise interest rates more quickly as the output gap closes more quickly.

A second possible reason why Trump might mean higher interest rates in the long run is fiscal policy.

Republicans usually favour tax cuts but Trump has also talked about infrastructure spending. If we use the 1980s Reagan era as a precedent, then Republicans when in power, and despite favouring small government, have in practice found it difficult to control the size of the fiscal deficit, finding it easy ideologically to vote for tax cuts but harder, pragmatically, to vote for cuts in public spending (older readers may recall that it was Bill Clinton's Democrat presidency in the 1990s, rather than the Republicans,  that pursed the policy of reducing the fiscal deficit with the aim of reducing in turn long term interest rates).  Thus with Republicans controlling the White House and being the stronger party in Congress we may expect higher fiscal deficits and correspondingly more issuance of Government bonds. Larger expected deficits and bond issuance would tend to drive the yield on longer term Treasury Bonds upwards and in turn push shorter term interest rates up with it.

(The investment strategy that would follow from this would be to keep your bond style investments relatively short term for now. Be careful if are considering buying so-called safe assets such as Government bonds at this time when their prices are bid up - as they may decline in value later as the new President's actual agenda becomes clearer and markets focus on the longer term issues of the fiscal deficit and the output gap)