Hopes for cooling inflation are stifled by Wall Street's expectations for Trump 2.0

By Vivien Lou Chen

`It's about an election that can fundamentally change the inflation picture for the next three to four years to come. And parts of the market are already worrying about that picture,' one inflation trader says.

Just as many investors and traders remain sanguine about the prospects of cooling U.S. inflation when Thursday's consumer-price index for June comes out, Wall Street is pointing to the potential inflationary impacts of a second presidency under Republican Donald Trump. What's emerging ahead of the CPI report's release in a few days are two contradictory notions about where U.S. inflation is likely to be headed in the months and years ahead - complicating the Federal Reserve's analysis of the most appropriate path for interest rates, which remain at 23-year highs of 5.25% to 5.5%. Major U.S. stock indexes DJIA SPX COMP closed mostly higher on Tuesday, sending the S&P 500 and Nasdaq Composite to more record closes, despite a selloff in U.S. government debt that pushed up 10- and 30-year Treasury yields for the first time in five sessions.One train of thought is that inflation will probably keep easing as U.S. growth slows - giving the Federal Reserve the ability to cut interest rates as soon as September. Economists expect the annual headline CPI inflation rate to fall to 3.1% in June from 3.3% in the previous month, and inflation traders envision the rate continuing to drop toward 2% through May 2025.The other line of thinking is that inflation could rear its head again if Trump is elected to the White House due to his proposals on trade and immigration. Parts of the financial market expressed worry about Trump 2.0 via a two-day rise in Treasury yields on June 28 and July 1, even with four months left to go before Americans cast their votes. "For good reasons, traders like to link Trump's policy agenda with inflation," said Thierry Wizman, a New York-based global FX and rates strategist at the financial-services group known as Macquarie. "They see policy rates being higher than otherwise under Trump 2.0."Trump is leading President Joe Biden in polls almost two weeks after their June 27 televised debate, putting the focus on the Republican challenger's proposals for 10% duties on all imports and minimum 60% tariffs on Chinese goods. To be fair, Biden has also taken the brunt of the blame for the run-up of U.S. inflation that began in 2021 and peaked in 2022, following his Covid-relief plan that led to an additional $1.9 trillion of federal spending.Last week, Jan Hatzius, chief economist of Goldman Sachs (GS), said in a presentation made at the European Central Bank's annual conference in Portugal that Trump's 10% tariff proposal could trigger reciprocal actions by other countries. When factoring in the trade war that might unfold, Hatzius estimated that this might end up lifting U.S. inflation by 1.1 percentage points and leading to five extra quarter-point rate hikes by the Fed.

Separately, strategist Steven Zeng of Deutsche Bank (DB) has flagged the likely impact of Trump's immigration-policy agenda on U.S. interest rates. In the short term, larger immigration flows have "acted as a positive supply shock and contributed to the Fed's ability to cut rates," Zeng said. "Consequently, a reversal of these flows could result in higher wage inflation and a more hawkish stance from the Fed." After Fed Chairman Jerome Powell's first day of congressional testimony on Tuesday, fed-funds futures traders priced in a 70% chance of a quarter-point rate cut by September. Despite the market's expectations for a September rate cut by Fed officials, "I don't see them cutting at all in 2024," said inflation trader Gang Hu of WinShore Capital Partners in New York. Hu added that even though investors are focused on June's CPI report on Thursday and Powell has reiterated the need for more signs of cooling inflation, the outcome of the Nov. 5 presidential election "could drastically change everything so the Fed needs to tread carefully." "Right now, it's all about Trump. That's the major theme and the Fed cannot ignore the possible election results at all," Hu said via phone. "It's about an election that can fundamentally change the inflation picture for the next three to four years to come. And parts of the market are already worrying about that picture." The Fed's job is to control inflation so policymakers will probably need to consider the potential impact of Trump's tariff proposals, as well as his call for immigration reforms. Immigrant workers have been seen as helping to boost the U.S. labor market, by taking jobs in areas where labor has been difficult to find. Meanwhile, Trump has proposed deporting millions of undocumented workers.On Tuesday, Powell avoided getting drawn into a line of questioning from a lawmaker, who focused on Trump's tariff plans. Then, when asked about inflation in the 1970s, the Fed chair noted that "inflation kept coming back" after officials hadn't gotten the job done of completely curtailing price gains. Powell also said the current era of inflation has been characterized by supply shocks and demand shocks stemming from the reopening of the U.S. economy after the onset of the Covid-19 pandemic.

"The Fed is absolutely not going to go anywhere near Trump's policies by talking about them," said economist Derek Tang of Monetary Policy Analytics in Washington. "Instead, it's going to be trying to walk along the lines of saying that forecasts are uncertain coming out of Covid and they [policymakers] will use that as cover to gloss over any Trump-related risk" ahead of the Nov. 5 election. "Politics clearly matter to the economic forecasts in 2025 and 2026, but the Fed is going to pretend that it doesn't, so that's the gray area that they are operating in," Tang said via phone on Tuesday. "The issue is, 'Should they cut rates if the spot data says yes, but the forecast says no and the forecast is a judgment about who is going to win the election?' My guess is that policymakers will start easing by September or December, and if they have to reverse course by hiking, they will" - which could become even more problematic by confusing investors.

-Vivien Lou Chen

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07-09-24 1603ET

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