Treasury yields have surged by about 60 basis points since the Federal Reserve eased monetary policy at the September FOMC meeting (see chart below). The Financial Times observes that this move has “sent ripples through markets from gold to currencies, as investors warn that volatility is ‘locked in’ ahead of next month’s presidential election.”
During this span, the dollar has appreciated by 7% and 4% against the yen and the euro, respectively. The price of gold has also surged to its highest level this year, rising by 33% for the year amid increased uncertainty about the economic and political landscape.
The Upward Shift in the Treasury Yield Curve
The main reason for the increase in Treasury yields is that economic data have been stronger-than-expected since the FOMC meeting. Fed officials expressed confidence then that inflation was coming under control, but they did not want the unemployment rate to rise significantly further. Meanwhile, nonfarm payrolls rose by 254,000 in September, and there were upward revisions for the two prior months totaling 73,000. Consequently, the unemployment rate has fallen to 4.1% from a peak of 4.3% in July.
As a result, investors are anticipating a more gradual pace of Fed easing in which it will cut rates in 25 basis point increments instead of 50 basis point moves. The bond market is now pricing in that the funds rate will end this year around 4.5% and next year at about 3.5%. This outlook is in line with the view I presented in a commentary for The Hill following the September FOMC meeting.
Beyond this, financial markets also appear to be pricing in a Trump win in next week’s election.
Bond investors, for example, may be taking into account the effect that the combination of tax cuts and tariff hikes that Trump is espousing could have in driving up future budget deficits and inflation. This has showed up as an increase in the so-called term premium that compensates investors for increased risks over the long term. This is reasonable considering that prospective federal budget deficits are likely to remain outsized irrespective of the outcome of the presidential and congressional elections.
I differ, however, with the assessment of currency traders who anticipate the dollar will stay strong if Trump becomes president. Their logic is that if Trump were to enact significant tariff hikes, they would reduce goods imported into the U.S. and thereby reduce demand for foreign currencies, as well.
In my view, this is a short-term assessment and only the first step in the analysis. One also has to factor in the effect that higher tariffs would have in increasing the costs of imported inputs, which would make U.S. exports less competitive over time.
This insight is consistent with the Lerner Symmetry Theorem that states that import tariffs and export taxes have the same effect on relative prices. It helps explain why the U.S. current account deficit did not shrink during the trade conflict with China in 2018-2019 and why U.S. jobs in manufacturing did not increase materially, as Trump asserts.
A report by the conservative-leaning CATO Institute documents economic studies that show “American consumers (both firms and individuals), not foreigners, paid for – and continue to pay for – the tariffs.” The report concludes that Americans face significant losses from tariffs (and inevitable foreign retaliation), including higher tax burdens and prices, and loss in wages and employment among other adverse effects on the economy.
Beyond this, it is important to consider how staunch Trump and his former U.S. Trade Representative, Robert Lighthizer, have been in advocating a weaker dollar to improve U.S. international price competitiveness.
Both Trump and Lighthizer have clung to this position since the 1980s, when the dollar was at record highs and the U.S. ran record trade imbalances. The dollar stayed strong in the first half of the 1980s on the back of high U.S. interest rates. But it fell significantly in the mid-1980s, when the U.S. economy weakened and President Reagan altered his strong dollar stance while the Fed eased monetary policy.
The case for a weaker dollar today rests primarily on two considerations. First, the dollar appears considerably over-valued based on calculations that take into account differences in inflation rate differentials with our main trading partners. For example, the real broad dollar index calculated by the Federal Reserve shows that it is roughly 15 percent higher than its level twenty years ago (see chart below). This has contributed to a widening of the U.S. current account deficit in the past few years.
Real Broad Dollar Index, 2006 to present
Second, the Federal Reserve is likely to ease monetary policy as long as inflation stays in check. The case for doing so is that real interest rates are in the vicinity of 2 ½%, which is above the historical average. As a result, interest-rate differentials favoring the dollar are likely to narrow over time as the Fed lowers rates.
My bottom line is that higher Treasury yields are manageable, but a strong dollar would be problematic considering how over-valued it is and the widening U.S. current account deficit. The risk is that it could fan the flames of protectionism and thereby heighten financial market volatility.