Global Watch – Republican sweep raises risks to the outlook
Republican clean sweep makes it significantly easier to implement full policy agenda. Risks very firmly tilted to the downside for US and global economic growth and to the upside for US inflation. While Fed policy could be tighter than our current base line, the ECB could cut rates faster. Republican sweep sets the stage for US-European rates divergence. Parity for EUR/USD could be on the cards. We will publish an updated macro and market base scenario later this month.
After an exciting and tumultuous campaign, the US has decided its next president. The winner is Donald Trump. The implications of the election also very much depend on the makeup of Congress, and the Republicans are heading for a clean sweep, gaining majorities in both the House and Senate. At this point, the Senate is already taken by the Republicans. While the House race is still open, it is expected to go to the Republicans. This has major repercussions for the feasibility of Trump’spolicy plans, as a the two majorities in Congress will make it significantly easier to push through tax and trade policy. We’ve done extensive research on the potential macro impact of the various policy plans (see for an overview), but the combined effect is of course not as simple as adding a number of impulses, as the total policy package will interact. The actual magnitude and timing of the implementation of the various promises is still a big open question.
As we’ve flagged before, the fact that President Trump won, greatly increases the span of potential outcomes. Some of his plans have the potential to spur growth. Corporate tax cuts and various deregulation promises may boost activity and confidence, especially in the near-term. However, others have the potential to significantly worsen the economy, predominantly the plans for trade and immigration. The latter, if implemented, will increase inflation, forcing the Fed to react by increasing rates or at least keeping them higher for longer. These increased downside risks spill over to Europe. It is important to realize that most damage would be done under a universal import tariff. If the ultimate implementation is non-universal, the hit to the global economy would be significantly weaker. However, the full Trump package, including a universal package, would likely hit the global economy hard.
In addition to the increased risks in economic policy, there is an increase in geopolitical risks. Here too, there is great uncertainty on the shape and extent of the Trump’s administration impact, but it is likely that it will have consequences for NATO, and the ongoing wars in Ukraine and the Middle East. What seems almost certain is that the Trump administration will stop the climate-related spending from the IRA, an enormous setback to the US’ transition to a more sustainable economy. His plans for the various institutions also have the potential to severely impact the economy in the medium to longer-term.
At this point, there are still too many open questions and we can only talk about risks, which are tilted very firmly to the downside for US and global economic growth and to the upside for US inflation. Once the dust settles, and risks become reality, they will have an impact on our outlook for the US economy. We will be publishing an update macro scenario later this month, We do not expect them to have an impact on tomorrow’s Fed decision, not adjusting policy based on potential policies, similarly only reacting once they become a reality. (Rogier Quaedvlieg)
Republican sweep sets the stage for US-European rates divergence
Given the inflationary expectations associated with Trump’s economic and fiscal policies, we expect US rates to continue rise across the yield curve. We anticipate that the market will further retrace expectations for Fed rate cuts next year due to increased inflation projections, while also pricing in higher term premiums. However, our economic analysis suggests that the full implementation of Trump’s policies – especially the Tariffs – will eventually weigh heavily on the US economy. This implies that, despite higher inflation expectations, the market will also need to account for lower economic growth, indicating a potential stagflation scenario, which is likely to result in a flatter yield curve in the medium term.
Trump’s universal tariffs plan is also expected to have a substantial impact on the already fragile Eurozone economy, while the inflationary effects for Europe will be more limited. This could trigger an even more accelerated rate cutting cycle path from the ECB and will likely lead to a greater divergence between the US and European policy rates. This should support the short-end of the European curve; however, the long-end faces headwinds from the US. Indeed, we interpret the recent weakness of European government bonds partly as a direct consequence of the increasing likelihood of President Trump’s policies being enacted. Part of the rationale behind this view is that European governments might need to implement fiscal stimulus measures to boost economic growth, thereby exacerbating the already historically high deficits in Europe. Additionally, Europe faces further challenges related to defense, as President Trump’s threats to withdraw protection for European countries in the event of a Russian attack or to continue supporting Ukraine raise the possibility of EU countries needing to allocate more funds to establish a European defense system. However, over time, the direction of monetary policy will be the most powerful driver of the whole curve.
In our view, these factors potentially contributed to the significant tightening of swap spreads observed in Europe since October. The need for higher fiscal stimulus, resulting in increased supply on top of QT, may have led the market to already price in this scenario as bets on Trump’s victory rose during that period. If this is indeed the key trigger for the tightening development, then given Trump’s victory, we could expect to see further tightening pressure on swap spreads. However, a deterioration in risk sentiment could over time reverse this trend. Indeed, as we saw in 2016, sovereign country spreads are also at risk of widening pressures. In line with reviews of our macro scenario, we will be publishing an update of our rates views. (Sonia Renoult)
Parity could be on the cards
Ahead of the Elections, the US dollar strengthened when the probability of a Trump victory increased. In recent days the dollar weakened as some investors priced out the possibility of a Trump victory. When the results started to come in and former president Trump took the lead even in swing states, the dollar strengthened. Indeed, the US dollar index have rallied from 103.40 to a high of 105.25 or by 1.8%. EUR/USD dropped from 1.0937 to 1.0740.
As soon as it became clear that Trump will be the new president, the dollar extended its rally because of the expectations of an initial improvement in the trade balance as result of the trade policies/trade tariffs. In addition, the US would be subject to higher inflation compared to other countries and US interest rates would remain high for longer compared to elsewhere. Absent a European carve-out, a striking feature of the full tariff scenario is that it would lead to substantial monetary policy divergences between the Fed and the ECB. With the Fed raising rates or keeping rates high to fight inflation just as the ECB continues to lower rates likely at an accelerated pace, the widening interest rate differential is likely to weigh on the euro, possibly hitting parity. But a weaker euro would by itself do some of the easing work for the ECB, as it would (partially) offset the competitiveness hit from higher trade tariffs. However, later during the presidential term we expect the dollar to weaken again as the US economy weakens as a result of the policies.
Not only could the dollar be supported by the pricing in of initial positive dynamics, the dollar could also strengthen on safe haven demand (for its liquidity) if markets were to turn risk averse or even panic. (Georgette Boele)