Given yesterdays' market developments, we've updated Eddy's weekly market insight and have added consequences for the financial markets.
There’s a reason why, in most countries—including autocracies—the central bank has been made as independent from politics as possible. When control over the central bank, the only institution capable of managing money creation, falls into political hands, it almost inevitably leads to ballooning budget deficits financed by the central bank. History has shown time and again that this path results in significant economic turmoil: runaway inflation and highly inefficient government spending.
This lesson is particularly relevant for the United States today, as a substantial part of its budget deficit is financed by foreign investors. Without this steady inflow of capital—bolstered by the U.S. dollar’s role as the world’s reserve currency—interest rates in the U.S. would be much higher. That, in turn, would slow economic growth and further inflate an already unsustainable budget deficit. (Interestingly, the U.S. trade deficit, which Trump frequently criticizes, is the mirror image of this capital inflow—one cannot exist without the other. The large capital inflow is mainly due to the U.S. investing far more than it saves, driven primarily by its large fiscal deficit.)
What’s more, capital continues to pour into the U.S. because Treasury bonds are seen as virtually risk-free and are traded in such vast volumes that their prices remain stable. Crucially, the Federal Reserve’s independence has helped keep inflation under control, reinforcing investor confidence.
However, Trump has little regard for this independence. This week, he remarked that Fed Chair Jerome Powell—whom he appointed during his first term—should step down as soon as possible. Powell had pointed out that Trump’s import tariffs were fueling inflation and slowing economic growth, a message that struck a particularly sensitive nerve with Trump.
Even more troubling for Trump was the Fed’s conclusion that, under these circumstances, interest rates could not be lowered significantly in the near term. Trump, however, wants rapid rate cuts, believing they would act as insurance against slowing growth. That’s critical, as a slowdown would further inflate the already large fiscal deficit—a recession could push it from around 7% of GDP to over 11%—driving public finances off the rails and potentially triggering a financial crisis.
This all comes against a backdrop where Trump has previously claimed to know more about interest rates than the Fed and has suggested it’s time he had a say in the Fed’s policy decisions.
The current budget deficit reveals that the U.S. is living well beyond its means. Given the current phase of the economic cycle, the deficit should be close to 0%, or even a surplus. Instead, the total debt-to-GDP ratio has risen to such levels that the policy of continued borrowing is becoming unsustainable. Interest payments are starting to crowd out other essential government expenditures, and the trade deficit continues to widen.
Trump is trying to solve the symptoms rather than the root causes: tariffs to "fix" the trade deficit and pressure on the Fed to keep interest rates low. Ultimately, this can only erode confidence in the U.S. and its currency. The only way to prevent this is through a swift and decisive policy shift. Unfortunately, it appears that Trump is unlikely to act unless forced by a full-blown crisis.
This makes Trump’s next move regarding the Fed especially significant. Powell’s term ends in May next year, at which point Trump could appoint a new Chair—likely someone more aligned with his views. While the Chair’s influence is considerable, decisions are made collectively by the FOMC, which can vote against the Chair’s wishes. However, Trump has already made it clear that he wants more direct influence over the Fed’s decisions.
This is a critical issue for financial markets. It could pave the way for much higher inflation, elevated long-term interest rates, and a weaker U.S. dollar.
It is important to note, as previously mentioned, that Trump cannot simply impose his will on the Federal Reserve or dismiss the Fed Chair. To do so, he would have to overcome significant legal obstacles. However, considering Trump’s recent actions toward other institutions that oppose him, it is evident that he is willing to push, if not overstep, legal boundaries.
Foreign capital holders appear unwilling to wait for the outcome of such legal disputes. In the case of China and its allies, there is a particular fear that Trump might freeze or confiscate their reserves—similar to how the West recently dealt with Russian assets.
Adding to the unease are growing reports that the U.S. may consider withdrawing from the IMF. Such a move would fundamentally shake global monetary relations.
Our conclusion is that foreign investors will seek to minimize their exposure to the U.S. for the time being, and may even start pulling capital out. This has significant implications for global markets, as foreign capital has long played a key role in financing the U.S.
The main question is: Where will this capital flow instead? We believe the answer is primarily Europe. Through his geopolitical strategies, Trump has inadvertently brought European nations closer together, and they are increasingly forming a united front—geopolitically, militarily, and economically. Furthermore, many European countries are planning to increase fiscal spending on defense, infrastructure, and climate initiatives. This will likely stimulate growth and prompt the ECB to cut rates less than markets are currently pricing in.
Market Implications
- We expect the EUR/USD to remain in an upward trend, potentially moving towards 1.20 or even higher if Trump maintains his current course.
- Within Europe, the Swiss franc traditionally offers the best protection against geopolitical tension and fiscal instability. The currency is significantly supported by the central bank, although the SNB will likely try to prevent excessive appreciation.
- The British pound faces challenges due to the UK’s substantial fiscal and trade deficits, which require foreign funding—now increasingly scarce due to investor caution post-U.S. experience. However, the pound’s relatively high interest rate compared to the euro supports the outlook. We now expect EUR/GBP to hover around 0.87, while GBP/USD remains in an upward trend.
- A weakening U.S. dollar will likely push USD/JPY lower. Consequently, we expect the Bank of Japan to keep rates unchanged. This may lead to a modest appreciation of the yen against the euro, especially as the ECB is still likely to cut rates once more.
- As a result, the euro will continue to strengthen, and we no longer expect more than one additional ECB rate cut this year (previously we anticipated several).
- Gold prices are expected to stay in an upward trend.
- These capital shifts imply upward pressure on long-term interest rates in the U.S., and downward pressure in Europe.
- Consequently, we foresee downward pressure on U.S. equities and upward pressure on European equities.
Final WARNING: Given the extremely high total debt-to-GDP ratios in most countries, the above scenario could rapidly escalate into a financial crisis. Should that occur, Trump would likely be forced to reverse course dramatically. Market movements could then abruptly shift direction.
While the timing of such a crisis is impossible to predict, we would flag a warning if the yield on 10-year U.S. Treasuries—currently around 4.40%—rises above 4.80%. A yield above 5.00% would trigger a red alert, significantly increasing the likelihood that Trump will have to adjust his policies.
