In normal circumstances, Christmas is supposed to be a blissfully boring time for the Federal Reserve — and those analysts paid to watch it.
In normal circumstances, Christmas is supposed to be a blissfully boring time for the Federal Reserve — and those analysts paid to watch it.
However, 2018 is not a “normal” time; not with Donald Trump in the White House. Last week, the US president unnerved markets by imploring the Federal Reserve to stop raising rates. This week he intensified those attacks, hinting that he might fire Jay Powell, the Fed chair.
Steven Mnuchin, Treasury secretary, frantically tried to undo the damage, with a tweet (what else?) suggesting that Mr Powell’s job was safe. But the hapless Mr Mnuchin created additional alarm by revealing, in a formal statement, that he had spoken to the leaders of America’s largest banks to discuss their liquidity.
Unsurprisingly, that sparked some unfestive drama. On December 24, US equity markets posted their biggest recorded crash for a Christmas Eve. But on Wednesday they recorded their biggest rally for almost 10 years.
So what should investors make of this? If you want to be optimistic, you might listen to the explanation being offered by some members of President Trump’s cabinet: namely that this week’s events reflect a “normal market correction”, exacerbated by changes in market structures and some public relations hiccups.
Their argument goes like this: in the decade since the financial crisis, regulatory reform has prompted the banks to abandon their traditional market-maker roles. Electronic trading has exploded in scale, meaning that machines — not humans — shape trading flows. That has changed liquidity and left markets sensitive to jolts; be that bad economic news from China or ill-judged tweets or statements.
However, administration officials insist that the markets will calm down once investors remember that the American economy remains pretty strong. Or, as a senior administration official says: “Market structure issues have increased volatility in both directions and in hindsight we misinterpreted the PR issues [with the Mnuchin statement]. It was meant to be a signal that everything’s working fine, but it was misunderstood.”
This explanation is not entirely fanciful: market structures have changed in a way that makes price swings more unpredictable. But, for my money, there is another, darker, way to interpret this week’s events. Two years into Mr Trump’s presidency, global investors are questioning the administration’s financial credibility.
A cynic might argue that this challenge is not particularly new: Mr Trump has delivered endless policy surprises over the past two years because the president relies on brinkmanship to deal with domestic and foreign rivals. Just think of the trade war dramas or the stand-off over funding Mr Trump’s “beautiful wall” on the Mexican border (which has shut down parts of the federal government).
But what has changed is that the president has not merely sown disarray in the White House but has threatened to do so at the Fed, too. To be fair, he is not the first president to dislike higher rates, nor is his the only voice questioning whether Mr Powell is correct to keep raising rates.
By attacking the Fed in such a crude manner, Mr Trump has undermined one of the few Washington institutions that has provided a consistent, calming policy presence amid this year’s chaos. Worse, by demanding loose monetary policy the president has also signalled his desire for new sugar highs for the American economy, such as tax cuts or lower rates — no matter the longer-term cost.
Thankfully, this has not caused bond market jitters (yet). On the contrary, the 10-year yield is hovering at a mere 2.8 per cent. But it is worth remembering that President Trump’s attack on the Fed comes at a distinctly inopportune time: the federal budget deficit is exploding, and set to top $1tn next year for the first time. Plus, most economists forecast that growth will slow next year, without even factoring in further trade wars.,
It is worth remembering that President Trump’s attack on the Fed comes at a distinctly inopportune time: the federal budget deficit is exploding, and set to top $1tn next year for the first time
In most countries, such a pernicious cocktail would have sparked a currency and bond crisis. However, this has not yet happened in America because the US economy is relatively strong and the country’s government enjoys the so-called “exorbitant privilege” of controlling the world’s reserve currency (which forces global investors to keep buying its government bonds).
But one way to interpret this week’s events is that some investors are starting to ponder the limits of this privilege, or are wondering what will happen next. They are asking themselves: if the president forces Mr Powell to quit, what will happen to inflation? How many more short-term stimulants will Mr Trump try to produce? And if the deficit continues to explode, can we presume that investors will still finance it by buying bonds?
Some people around Mr Trump understand these risks. Hence the desire of men such as Mr Mnuchin and Kevin Hassett, chair of the Council of Economic Advisers, to tell investors that Mr Powell is staying in his job. But if, as widely predicted, American growth slows next year, the president will keep hunting for more sugar highs, and scapegoats, such as the Fed.
So the moral for investors is clear: do not panic about this week’s events. But steel yourself for more volatility in 2019. And keep your diaries flexible to cope with further turbulence triggered by Mr Trump (and his Twitter account).
