A week before Trump begins his second term, U.S. stock and bond markets are rebelling. But against what? I’ll explain below.
Stocks initially rose after Trump won the 2024 election, but all three major indexes (the Dow Industrial Average, Standard and Poor’s 500, and NASDAQ) are now below where they stood the day after the election. The Dow and S&P 500 have sunk below their pre-election levels.
Since Trump was re-elected, long-term interest rates have risen about 1/2%, despite three Federal Reserve interest rate cuts totaling a full percent. The Fed sets the overnight lending rate between banks, which in practical terms controls short-term interest rates. But long-term rates, such as 5 and 10 year Treasuries, and credit card and mortgage rates charged consumers, are determined by the bond market.
And bond traders, weighing what Trump’s plans will do to the U.S. debt and deficits, don’t like what they see. “The bond market is sending a message that investors are worried about the economic policies dead ahead,” Mark Zandi, a frequently quoted Wall Street economist, told Huffington Post (read story here).
Trump wants big tax cuts and has big spending plans. Together that means bigger deficits and more debt. This is why Trump wants the Congress-imposed debt ceiling repealed or at least raised. But the rank-and-file Republicans populating the GOP’s House majority include some members who are “deficit hawks,” i.e. they oppose more debt. In the past, and likely this time too, raising the debt ceiling has always required Democratic votes, which gives the Democrats a partial veto over GOP tax and spending plans.
It’s not politically possible to cut taxes without raising deficits. You can save a bit under $900 billion a year by having no defense. That’s not enough to eliminate the deficit. You could do that with deep cuts in Social Security and Medicare benefits to retirees, but those programs have their own tax revenues, and currently are fully funded by the trust funds those taxes go into, so that would be stealing from the retirement programs workers pay into to cover the government’s other expenses.
The problem is Republicans have cut taxes too much. From Reagan’s 1981 tax cuts onward, their tax policies have been paid for with Treasury borrowing, which has piled up more debt. That debt doesn’t have to be repaid, it can be rolled over, but a bigger debt requires spending more on interest. Rising interest rates also raise the federal budget’s interest expense, which now exceeds spending on defense.
If I can shift gears a bit — but this is relevant — Wall Street determines whether stocks are expensive or cheap by dividing earnings by stock price to get what’s called the price-earnings (P/E) ratio. It reflects the fact that stock is a claim on future earnings. This ratio is calculated for each individual stock, but also for the market as a whole using the S&P 500 as a proxy. The S&P 500 consists of “500 of the largest companies listed on stock exchanges in the United States,” according to Wikipedia (details here).
Right now investors consider the stock market expensive, because the S&P 500’s P/E is well above its historical average. It isn’t reverting to the norm for now because strong earnings growth is supporting high stock prices. But stocks are sensitive to bond yields, and the stock indexes have been on a choppy downward path since after the election because of what’s happening in the bond market.
Trump is sensitive to stock market performance. He uses it to grade himself and his policies. Congress, especially the Republicans, listens to Wall Street too. And while ordinary voters may not immerse themselves in financial market news, they pay attention to mortgage, credit card, and personal loan rates. For them, that’s money going out of their pockets.
This could spell trouble for Trump’s agenda and the GOP’s wish list of tax cuts and spending plans. They not only want to extend his 2017 tax cuts, which expire at the end of 2025, but expand them by not taxing tips, increasing the child tax credit, raising the state-and-local tax deduction, and in other ways. But that will put deficits on steroids, unless they can pull off deep (and deeply unpopular) spending cuts to Medicare, Medicaid, food stamps, and other social welfare programs.
They would like to do that, and are talking about it (see my posting here), but it’s easier said than done. For example, Medicaid pays for 90% of U.S. nursing home care, such that nursing homes can’t exist without Medicaid payments unless they’re sponsored by a church or other deep-pocketed private charity. Medicaid also provides health care for millions of low-wage workers and low income families.
The House GOP’s wish list of spending cuts might push helpless elderly people out of nursing homes on the streets, and at minimum would throw tens of millions of Americans off their health coverage. Even if they’re willing to do that, they’d risk a fearful voter retribution in future elections. Their political self-interest argues against it.
If something has to give, it won’t be bond yields. Investors can’t be forced to buy government and private debt. They can push up interest rates to pay themselves for the increased risk that bigger deficits and higher debt pose to their investments, including the risk of eventual default. Or they’ll stop buying government debt altogether, resulting in a fiscal crisis and probably economic collapse.
What will give is fiscal policy, i.e. taxing and spending. Essentially, the bond market has something approximating a veto over what Congress does with taxes and spending. James Carville, who managed Bill Clinton’s 1992 campaign, says if he’s reincarnated he wants to “come back as the bond market, because you can intimidate everybody,” including congressional tax and budget writers (quoted in Huffington Post story linked above).
The bond market is stirring, as shown by the fact market-set bond interest rates are rising despite the Fed lowering policy interest rates, and also by the stock market’s gradual and bumpy decline since the election. Huffington Post says bond traders are “flashing warning signs about the GOP’s plans,” and even headlined its story, “How Wall Street Could Wreck The GOP’s Tax Cut Plans.”
I think this headline accurately reflects what’s most likely to bend under pressure: Trump’s and the GOP’s cherished tax cuts. Republicans claim America has a spending problem, but it really has a revenue problem. Democrats certainly have spent money; Biden spent money on things like bridge repairs, rural broadband, and accelerating the transition away from fossil fuels. And both parties spent big on Covid relief. But even without all that spending, there would be deficits.
That’s because the bulk of federal spending goes for Social Security and Medicare, other health care, defense, and debt interest. The deficit exceeds discretionary spending, therefore can’t be eliminated through spending cuts without going into mandatory spending. Unless we’re willing to put America’s elderly into grinding poverty, and eliminate health care for half our population, we either have to pay higher taxes or live with deficits and ever-rising debt.
The bond market may not let us get away with coasting along with deficits and debt. (If you’re wondering how we’ve managed it, the answer is the dollar is the world’s reserve currency, which allows us to offload a lot of debt on the world economy. If other countries ever abandon the dollar, we’re screwed.) If investors stop financing government borrowing, or the Treasury defaults on paying interest on existing debt, the entire economy will crash and burn. Then we’ll all be desperately poor.
Even Republicans don’t want that outcome, so I think the rising interest rates and a weakening stock market will pressure them to reign in their spending and tax cut plans. They won’t give up their agenda entirely, but they’ll tap the brakes despite protests from Trump. If they don’t, the “bond market vigilantes” may surface with a vengeance. Given the strong desire of Republicans to carry out their plans, I’m looking for some arm wrestling between Trump, Congress, and the financial markets in the weeks ahead; and I think the Republicans, not Wall Street, will yield in this shoving match.