A first week of Trump bumps and bluster leaves markets guessing but hopeful

Markets are optimistic about the outlook for Trump’s policies, although a strong dollar and higher interest rate could eventually challenge US ‘exceptionalism’, says Westpac’s Luci Ellis.

Westpac economist and former RBA assistant governor Luci Ellis. Picture: Jane Dempster

There was plenty of action on financial markets as Donald Trump took office this week.

The US dollar shied off a two-year high, the 10-year Treasury yield hit a three-week low and the S&P 500 hit a record high, crude oil prices hit two-week lows, gold soared 2.7 per cent and bitcoin hit a record high.

Al this as the US President spoke of tariffs, immigration, energy, interest rates, artificial intelligence and digital asset policies.

However, the VIX, which measures market volatility, cooled and it was down from 16 per cent to 15 per cent.

The dollar rose more than 2 per cent to US63.24c after bouncing off an almost five-year low of US61.31c a week earlier. And the benchmark ASX 200 stock index rose about 1 per cent to 8405 points.

Trump flagged February 1 as his potential start date for a 25 per cent tariff on goods from Canada and Mexico, and an additional 10 per cent tariff on Chinese products. His plan for Canada and Mexico was in line with his presidential campaign threats and above expectations. He also warned that the European Union would be “in for tariffs”.

But his pronouncement to increase the tariff on Chinese goods from 10 per cent to 20 per cent was well below his previous call for 60 per cent; and there were no “day-one” tariffs or “universal” 10 per cent tariffs as previously threatened.

However, a presidential memorandum on the “America First Trade Policy” now requires government agencies – including the US Trade Representative – to issue reports on a range of trade-related issues by April 1.

Trump has sent 1500 troops to the US southern border in preparation for his promised deportations and announced project “Stargate” to harness $500bn ($800bn) of capex from tech giants for artificial intelligence development.

He also signed an executive order to create a working group to advise the White House on digital asset policies. The working group includes federal agencies, like the Treasury Department, Justice Department, Securities and Exchange Commission and the Commodity Futures Trading Commission.

The group will be tasked with submitting a report to the president in six months on a regulatory framework and legislative proposals, including evaluating the creation of a digital asset stockpile.

In a speech to the World Economic Forum at Davos, Switzerland, Trump said he would ask Saudi Arabia and other OPEC nations to “bring down the cost of oil” adding that “with oil prices going down, I’ll demand that interest rates drop immediately. And likewise they should be dropping all over the world”.

Those comments pushed the S&P 500 up 0.5 per cent to a record high close of 6118.71 on Thursday.

However, OPEC and the Federal Reserve are independent of the US government.

Any attempts to pressure the Fed to cut interest rates could backfire by increasing inflation expectations and could spark damaging falls in the US dollar and Treasuries.

“Perhaps the most significant development in Trump’s rhetoric over the past few days has been his less hawkish China language,” said NAB head of market economics Tapas Strickland.

Trump stated on the US-China relationship: “We have to make it just fair. We don’t have to make it phenomenal. We have to make it a fair relationship. Right now. It’s not a fair relationship.”

Similarly in a Fox News interview Trump downplayed issues about social media platform TikTok and national security.

He also seemed to indicate that the threat of tariffs was a bargaining tool.

“We have one very big power over China, and that’s tariffs, and they don’t want them, and I’d rather not have to use it,” he said in the Fox News interview.

But in terms of concrete announcements it was largely a case of “wait and see”.

And as much as Trump wants to lower interest rates by increasing oil supplies, thereby lowering oil prices, a deeper question on the outlook for interest rates exists. After all, the economy has been remarkably resilient to sharply tighter monetary policy in recent years, and significant tariff increases could spark at least a temporary increase in inflation and Trump wants to lower US tax rates further.

But a rising long-run “neutral” rate of interest and overvalued exchange rate may eventually “bite the US exceptionalism narrative,” according to Westpac chief economist Luci Ellis.

“It has long been our view that wherever neutral is, it is higher than it used to be,” she said.

Central banks have revised upwards their estimates of neutral over the past year.

According to the “dot plot” of Federal Open Market Committee members’ views on the “long-run” level of rates, the Fed’s estimates of neutral are centred on 3 per cent or a touch below.

“This is still a little below our own view that this longer-run concept of neutral is likely to be somewhere in the low to mid 3s,” Ellis said.

Depending on how quickly central banks pivot their thinking, some may need to backtrack on rate cut projections as they find that the neutral rate they were aiming for is higher than they thought.

“This evolution, and the likely policy actions of the Trump administration, underpin our current forecast that the Fed will start raising rates again in 2026,” Ellis said.

“Policymakers never forecast that they will end up backtracking, so the ‘dot plot’ shows a smoother convergence without a turning point.

“But it’s also plausible that the smoother path implied by the ‘dot plot’ occurs because policymakers revise up their estimate of the neutral rate further.”

Thankfully, the Reserve Bank may not have to revise up its estimates of neutral in the near term.

Its models already imply that the neutral nominal cash rate is in the mid 3s, and the recently adopted checklist approach to assessing broader monetary conditions will reduce the risk that statistical inertia in those models leads to underestimates of neutral, according to Ellis.

However, most published measures of the real effective US dollar exchange rate show it at levels surpassed only by the mid 1980s era that ended in the Plaza Accord.

“Higher interest rates and a seemingly overvalued exchange rate – one can’t help thinking that reality will bite the US exceptionalism narrative sooner or later,” Ellis said.

Originally published as A first week of Trump bumps and bluster leaves markets guessing but hopeful