Donald Trump’s return to the White House on Monday has the world economy on tenterhooks. Could the 47th US president govern broadly as he did last time, when his most extreme threats were ultimately softened? Or is this time different?
Corporate America’s biggest beasts have cosied up to the president-elect, but there are also serious jitters on Wall Street, amid investor fears that Trump’s most colourful campaign rhetoric will soon become a reality: risking a fresh inflation shock in the world’s largest economy.
Rising prices would in turn devalue the money received for owning US government bonds, leading the markets to demand higher returns for holding its debt. From a low of about 3.6% in September, the yield – in effect the interest rate – on US 10-year Treasury bonds peaked close to 4.8% last week, before better-than-expected inflation figures helped sink it back to about 4.6%.
The rise in US borrowing costs reflects investor concerns over stubbornly high inflation and interest rates, with the potential that the incoming president’s policies could add to an already sticky economic outlook. It’s a rise the Nobel prize-winning economist Paul Krugman has suggested could show an “insanity premium” for the US in global markets.
“The bond market [is] starting to suspect that Trump really is who he seems to be,” he wrote earlier this month.
Experts warn Trump’s threat to impose tariffs of 60% on China and 20% on other countries, alongside the prospect of trade wars with Mexico and Canada – labelled the “51st state” by the president-elect – would drastically stoke inflation. His proposals to deport undocumented migrants could also choke the US labour supply, further adding to the pressure.
However, investors hope Trump may soften his approach, particularly if bond markets take fright.
“He’s so sensitive to financial markets because of his ego,” says Jamie Constable, markets strategist at Singer Capital Markets, who believes the next meeting of the US Federal Reserve on 29 January could be a flashpoint.
“Within nine days of his inauguration, he could get pretty vocal. I expect a lot of rhetoric on the need for Fed rate cuts. He’ll rant, but bond markets will have their view,” he says. If the US 10-year bond yield were to rise above 5% – a symbolic threshold – it could trigger a sell-off in stock markets, forcing the president to “rein back” his policies, Constable adds.
Share prices on Wall Street have rallied close to record highs, partly fuelled by an anticipation that Trump cutting taxes and slashing regulation would be good for US company profits. However, Albert Edwards, the chief global strategist at Société Générale, who is known as an “uber bear” in the City for his downbeat views, thinks there are parallels with 1987 – when persistent US budget deficits, rising interest rates and heady stock market valuations triggered the Black Monday financial crash.
“Eventually, something will surely snap, just like it did in 1987,” he wrote in a note to clients earlier this month, recommending investors take “extreme caution” in the year ahead. “As politicians in the US (and elsewhere) apparently have zero appetite for fiscal tightening, the bond vigilantes are slowly waking from their Rip Van Winkle slumber.”
Trump’s tax plans have investors worried about the US’s already ballooning federal budget deficit. Fuelled by Joe Biden’s Inflation Reduction Act (IRA) investment spree, the federal deficit reached $1.8tn (£1.5tn) in 2024, while the US’s overall debt pile – at more than $35tn – is worth 123% of GDP.
On the campaign trail, more than $7.8tn of tax cuts and only $4.7tn of offsetting policies – largely through tariffs – were promised by the president-elect, putting the US on course for a deficit increase of $3tn.
There could be little reason to panic. The US typically enjoys a funding advantage relative to other nations, helped by the dollar’s status as the global reserve currency – ensuring demand for US government bonds, known as Treasuries, which successive administrations have sold to cover yawning budget deficits. The US Federal Reserve has also helped, having bought Treasuries in unprecedented volumes since the 2008 financial crisis.
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However, the fiscal arithmetic may prove increasingly challenging. Meanwhile higher inflation has turned the Fed’s focus to getting out of the bond market, not deeper into it. “The argument that the US government can borrow in extremis because the dollar is the world’s reserve currency surely won’t hold good forever,” said Edwards.
Last week Janet Yellen, the Treasury secretary, warned the US was on an unsustainable path and could provoke a “debt crisis” in future. Attacking Congress for failing to back the outgoing administration’s deficit reduction plans, she said investment was still required to shore up the US economy, while arguing against inequality-stoking tax cuts.
In response, Scott Bessent, the hedge fund manager picked by Trump to replace Yellen, has a plan known as “3-3-3”: reducing the federal budget deficit to 3% of GDP, driving up economic growth to 3%, and producing an additional 3m barrels of oil a day by 2028.
Testifying at a Senate hearing last week, Bessent attacked Biden’s IRA spending as “wildly out of control”, but said the US would face an “economic calamity” if Congress failed to extend a multitrillion dollar package of temporary tax cuts made by Trump in 2017 which is due to expire in 2025.
However, some analysts are sceptical. The Center for American Progress thinks Bessent’s plans would require massive cuts to anti-poverty schemes and middle-class tax increases, while renewing tax cuts tilted to the wealthy.
City investors also say bond markets will be monitoring developments closely.
“We will be watching fiscal policy. This has become crucial for markets during and since the pandemic, and nowhere more so than the US,” says James Bilson, fixed income strategist at the investment manager Schroders.
“Given demographic headwinds, projections are for deficits and debt to be on an explosive path. For bond markets, this is a problem – and one that market pricing is clearly responding to.”
