Could USD interest rates increase if Trump brings the trade deficit down?
The Trump administration’s decision to impose significant tariffs on goods imported from foreign countries shocked politicians and the public across the globe and caused considerable market reactions. Equity and commodity prices dropped sharply since president Trump’s Liberation Day Tariff Announcements last Wednesday. Remarkably, US Treasury bond yields initially fell, but started to increase this week. By today, the yield of the 10-year US Treasury note trades at a yield of around 4.40 percent – virtually at the same level as before the announcement and 50 basis points above the temporary low of 3.90 percent reached on Friday. What does this unusual market reaction tell us?
As a well-known market pattern, bond and equity prices are normally negatively correlated. In anticipation of a possible recession, stock prices fall because of expected lower future earnings. By contrast, bond prices increase as their yield declines, typically anticipating a series of interest rate cuts during a recession. President Trump is quite vocal about his expectation that the Federal Reserve should lower interest rates immediately and he wants US citizens and the economy to benefit from lower lending rates. Yet, USD interest rates moved upwards in the last trading days, perhaps surprisingly to him.
It seems that the Trump administration overlooked a core macroeconomic link. Their aim to fight the US’ notorious trade deficits with most foreign nations means also lower capital inflows. This follows from the balance of payments, which mirrors the trade balance and the net import or export of services.
Economies with high consumption rates tend to import more goods than they produce. To finance their purchases of goods, they often have to borrow money from abroad (unless their imports of goods are compensated by exports of services). Conversely, exporting economies require a high savings rate. A net export of goods is only possible if domestic inhabitants consume less than they could based on their income. The domestic savings are typically partially invested abroad, helping the importing country to fund its trade deficit.
Since many decades, US inhabitants tend to spend a large portion of their income. To satisfy the high demand for consumption, the US imports goods from other parts of the world, in particular Asia and Europe. In addition, the US government runs large deficits. The US is the driver of growth in the world economy. However, it critically relies on other nations investing their savings in the US. Countries like Japan, China and the UK hold US treasury bonds in the hundreds of billions.
A reduction of the US trade deficit means that foreign countries can export less than before, achieve a lower income, and hence have less money left for savings. As a consequence, the demand for US treasury bonds may weaken in the coming quarters. Yet, the US household deficit needs to be funded. To attract either additional capital inflows from abroad or incentivize domestic households to more savings, higher USD interest rates are inevitable.
The brusque unilateral measures and provoking statements made by president Trump irritate most foreign trade partners. Foreign investors may increasingly lose confidence in the current US government and could review their investment strategy. If they fear about the safety of their investments, they may withdraw from the US bond market. While we regard a massive offloading of US treasury bonds by Japan, China or other foreign nations as an unlikely worst-case scenario, a lower appetite for investments in the US is a reasonable scenario. In our view, it is not unlikely that some overseas investors may not prolong maturing treasury bonds, and some nations could also temporarily suspend their treasury subscriptions until the tariff disputes are resolved to their satisfaction. If a repatriation of funds occurs, the room for lower bond yields is limited and we could even see yield increases, coupled with a weaker USD against most currencies.
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