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Bond yields can short-circuit plans to cut taxes and impose tariffs.
In Autumn 2022, UK Prime Minister Liz Truss discovered that there was a limit to the fiscal profligacy that 21st century bond markets would permit. Rumours of the death of the bond market vigilante were greatly exaggerated, it transpired.
Donald Trump would be wise to heed this warning. He hopes that tariffs, tax cuts and deregulation will increase demand for US-produced goods and services in the short-term, while spurring investment and increasing production capacity in the future. However, if bond markets don’t believe he can achieve these goals without triggering unacceptable levels of inflation, their scepticism can become self-fulfilling. A rise in yields might lead to adjustments in demand, investment, and employment, potentially challenging the economic and political viability of his policies.
Long-term interest rates consist of two main components: real return and inflation compensation. If markets view policy as unsustainable but trust the Federal Reserve (Fed) to respond appropriately, real rates may rise to pull the brakes on growth and, consequently, on policy ambitions. If there’s doubt about the Fed’s ability to act, implied inflation rates may rise to take more of the strain. Monitoring these scenarios will provide insight on the viability of Trump’s plans. He will need to tread softly and sensitively if he hopes to succeed.
