The Fed vs Trump: The Battle is On

US President, Donald Trump has become increasingly critical of the US Central Bank in the last 6 months. Last week he went as far as to say the Fed had ‘gone crazy’ and was ‘out of control.’ The Federal Funds Target range is now 2 to 2.25%, still close to the lowest it has been in 60 years.

The essence of Trump’s argument is that the Fed is raising rates too fast, and this will cause growth to stall. He feels there is insufficient evidence that inflation will return, and rate hikes are unnecessary at this stage.

His comments seem to have a lot to do with the stock market which has seen a marked increase in volatility over the last two weeks. Trump has been quick to point out each new stock market high, and lower prices remove his ability to do so. But whether the stock market weakness is a result of interest rates, the trade war or something else is almost impossible to determine.

Separately, Trump has also threatened to intervene to weaken the USD. This would be unprecedented and highly unusual – but then Trump is not like most presidents.

With the last rate hike came an indication that the Fed’s era of adopting and accommodative stance was over. In addition, the USD rose more than expected after the market had time to consider the remarks. As it stands, the Fed expects to hike again in December, and three more times next year. Trump is not likely to be pleased with any of this.

He is not alone in his criticism of the Fed. Many believe the Fed policy is based on outdated theories. Analysts also point out that higher rates lead to a stronger USD, offsetting the effect of import tariffs. So, for Trump not only are higher rates a threat to the economic growth he likes to take credit for, but they are harming the trade war he is waging with China.

However, the Fed may still have a point. Tax cuts and federal spending is only just the beginning to filter into the economy. When one considers that unemployment is already at very low levels, the combination could lead to a sudden jump in inflation in the next two years. Raising rates now will also give the Fed room to act if growth does hit a wall in a year or two. Furthermore, it may be just as likely that if the economy does slow, it will be because of the trade war rather than interest rates.

Nevertheless, the technicalities are probably irrelevant when it comes to President Trump. If he decides to go to war with the Fed, it’s not going to be an academic debate.

Increasingly, analysts are talking about the Fed potentially becoming politicized.

Three out of seven Fed governor seats remain vacant, and Trump can influence the Fed with the people he nominates to fill those seats. One of those seats may be taken by Michelle Bowman who is due to be confirmed by the Fed shortly. His other picks are actually facing resistance from his own party, the GOP. But, if they are not confirmed, he would have the option of nominating candidates with a more dovish stance – though he would still need them to be confirmed by the Senate.

Trump is also not happy with some of the members of the Fed he has already appointed. He stated that “I put a couple of other people there I’m not so happy with too but for the most part, I’m very happy with people,” which makes it quite possible that his attacks on the Fed are little more than rhetoric. Some have suggested that he just wants to have a scapegoat in case the economy does slow or there’s a market crash.

If Trump’s battle with the Fed remains one of rhetoric, there is little reason for it to have any implication for markets. The Fed will probably continue to raise rates gradually as they have indicated they will, only deviating from this plan if the circumstances change.

If Trump was to somehow manage to gain control or at least influence over the Fed, the implication would be that rates stay lower for a longer period. Ramping up the rhetoric could have a similar effect but to a lesser degree. So, what would lower interest rates mean for the various asset classes?

Equities

The S&P500 and the broader equity market would likely see increased volatility if tensions between the Fed and the White House escalated to the point where the source of policymaking became uncertain. But, in the event that Trump actually managed to put a lid on rate hikes, we would probably see asset price inflation, most noticeably in the stock market.

US Dollar

The implication of rates staying lower for longer would be for the USD to weaken against most currencies. The US Dollar index would be the obvious play as the Dollar would weaken against all major currencies.

Gold

In theory, lower rates would be bullish for Gold. In reality, there is little correlation between the two and the Gold price has disappointed more often than not in recent years. Still, any indication of Trump winning his battle with the Fed would probably lead to a knee-jerk rally for Gold. And, when we consider that Gold is still close to multi-year lows, the potential for a sustained rally is not a farfetched idea.

Emerging Markets

One of the consequences of lower rates and a weaker USD would be that import tariffs would be more pronounced. Even without tariffs, a weaker USD would lead to higher prices for imports. This would hurt China especially and would eventually hurt those countries that supply resources to China. That’s of course if the trade dispute were not resolved.

Geopolitics has a become a market mover. It is not enough to know the basic fundamentals but to follow political news and the effect of each world leaders move. For traders, that can be an opportunity.

All of this may be an academic exercise, but one worth thinking about in case Trump’s battle with the Fed heats up. Donald Trump is unlike previous US leaders and prone to going against the grain – it’s well worth preparing for the unexpected.