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The reaction of the markets to the US election
How should we interpret the reaction of the markets to the election of Donald Trump? The immediate reaction to the result was characterised by “risk off” behaviour with a fall in stock prices, US long-term interest rates and the dollar. However this initial trend, which was in all likelihood due to an increase in uncertainty, quickly reversed. Indeed, following Mr. Trump's acceptance speech, stock prices bounced back, US long-term interest rates rose substantially and the dollar strengthened. The rise in long-term interest rates was particularly pronounced, with the 10-year US Treasury yield climbing from 1.8% to 2.3% in a little over a week. What were the factors behind this sharp increase?
In the absence of precise information on any potential protectionist measures, the market was quick to focus on the new president's fiscal programme, an area in which the objectives seem rather clear. They suggest a large-scale fiscal stimulus with considerable investments in infrastructure and tax cuts for businesses as well as individuals.
What effects is this kind of fiscal stimulus likely to have? The US economy is currently close to full employment. In other words, if unemployment were to fall significantly below the current level of 4.9%, this should lead to an acceleration in wage inflation. The threshold below which such an acceleration in inflation would occur is referred to as the non-accelerating inflation rate of unemployment (NAIRU). According to Federal Reserve estimates, the NAIRU currently is somewhere between 4.7% and 5% in the United States. In such an environment, major fiscal stimulus, accompanied by a pick-up in short-term activity, could bring the unemployment rate down below the NAIRU, which should lead to an acceleration in inflation.
What would be the consequences for monetary policy? An acceleration in inflation would put more pressure on the Federal Reserve to raise its policy rates. This is the reason why market participants are now expecting a quicker pace of rate hikes than before the elections. In particular, the market now expects a rate hike at the December meeting.
The acceleration in inflation expected by the markets explains a large part of the increase in US long-term interest rates. However it is not the only explanation. By using part of national savings, a fiscal stimulus should also drive real rates upwards over time. In addition, the term premium has risen sharply since the election according to the estimates of the Federal Reserve. The term premium which compensates investors for the duration risk on long-term bonds increases with uncertainty. It is true that many questions remain unanswered, particularly with regards to potential protectionist measures and their possible effects on global trade.
BGL BNP Paribas
Published in the LëPublished on paperjam.lu on 1 December 2016.