Red Waves and Bond Graveyards: The Fed’s Nightmare in Trump’s America

We are what we pretend to be, so we must be careful what we pretend to be. – Kurt Vonnegut

by Pierre Daillie, Managing Editor, AdvisorAnalyst.com

"What are they supposed to do now?" muses Gavekal.¹ In a week filled with post-election jitters and bond market bruises, it seems Federal Reserve officials are waking up to the dawn of a distinctly Trumpian era—one in which deregulation, deficit spending, and the “growth-at-any-cost” mentality reign supreme. But amid the cheer for stock market highs and tech valuations bolstered by a robust U.S.-Japan yield differential, a sobering question looms: how long can the U.S. bond market stomach the pressure?

Let’s set the scene. BCA’s latest analysis² is clear-eyed, warning that “the most important transmission mechanism of a Trump presidency on the stock market will be via its impact on the US-Japan real yield differential.” This gap, with the U.S. yield towering over Japan’s, has kept the tech-heavy Nasdaq afloat, as capital flows from Japan provide critical liquidity to U.S. equities. For now, Trump’s win has sent stock prices and bond yields up together, as “the yen carry trade” feeds liquidity into American markets. But how sustainable is this euphoria?

A Red Alert for U.S. Bonds

Gavekal doesn’t pull punches. They caution that U.S. treasuries are flirting dangerously with a “Liz Truss moment,” an ominous reference to the U.K.’s bond market crisis last year that saw yields skyrocket and government stability falter. Their assessment is blunt: “Government bonds are selling off hard,” and the notorious TLT bond ETF is on track for its fourth year of negative returns. Rising yields may still track the nominal GDP, but as Gavekal notes, “the gap is closing fast.” We’re speeding toward a collision point, and with ten weeks left before Trump officially assumes power, there’s no steady hand on the Treasury tiller to ease market concerns.

BCA reinforces this, adding that while rising yields currently boost equities, this dance between stocks and bonds is unsustainable. The differential between U.S. and Japanese real yields “is at all-time extremes,” making it vulnerable to any shock that could force a rapid contraction in global liquidity. Should that differential narrow—whether due to falling U.S. yields, rising Japanese ones, or a mix of both—the supercharged valuations of U.S. tech could deflate just as quickly as they inflated. Their advice? Prepare for potential turbulence and consider diversifying away from U.S. mega-caps.

Déjà Vu: The Bundesbank Parallel

If you’re looking for an historical analogy, Gavekal’s comparison to the Bundesbank’s aggressive monetary stance during German reunification should catch your eye. Helmut Kohl’s generous fiscal policies—designed to uplift East Germany—clashed with the Bundesbank’s hawkish rate hikes. The result? A soaring deutschemark, currency crises across Europe, and a wave of forced exits from the European Exchange Rate Mechanism (ERM). Could we be on the precipice of an American echo? Gavekal reminds us that today’s Fed, like the Bundesbank then, faces a stark choice: submit to political pressures for growth or brace for a financial reckoning.

The parallels are tempting but incomplete, Gavekal cautions, especially given the U.S.’s unprecedented dependency on foreign capital and massive foreign holdings in U.S. assets. Wednesday’s rally in the dollar suggests global investors are keen on America’s renewed embrace of easy fiscal policy, yet they warn this assumes that “nothing else exciting” happens globally. The world stage, however, is rarely so cooperative.

Enter the Chinese “Bazooka”

Indeed, excitement may come from China, where an expected fiscal stimulus announcement looms. With Chinese equities hammered by the U.S. election results, “the market’s response to Trump’s win probably tilts the answer towards a bigger bazooka” from Beijing, writes Gavekal. Should China respond with aggressive stimulus measures, the Fed could find itself in a vice. How does the Fed reconcile its promised rate cut with massive fiscal expansions from the world’s two largest economies?

BCA suggests that any such global reflation attempt would only accelerate the narrowing of the U.S.-Japan yield spread, potentially kicking off the very liquidity crunch that’s haunting the dreams of tech investors. The path forward, they conclude, may entail a “structural underweight” on tech titans, favoring U.S. small caps and even non-U.S. stocks as a more resilient choice in this uncertain climate.

Indeed, today, China announced a $1.4T stimulus package, but nothing yet for consumers.

Betting Against the Yen and the Euro

Meanwhile, the yen’s persistent weakness is throwing another curveball. According to Gavekal, yen weakness—although linked to Japan’s political turmoil—adds a deflationary undercurrent to global markets. Trump and his newly-minted Vice President, JD Vance, have long criticized undervalued Asian currencies. With the dollar appreciating and the Fed tightening, how long can Japan resist a major recalibration of its own yield policies?

Across the Atlantic, Gavekal paints an equally precarious picture for Europe, where climbing rates “could easily push a country such as France into a full-blown fiscal and political crisis.” With Germany facing early elections, further instability within Europe is almost certain to pressure the euro, inadvertently granting the Fed some breathing room to cut rates. But it’s a temporary reprieve, not a sustainable solution

The Fed’s Dilemma: Cut, Resign, or Brace for Impact?

What’s left for Fed Chair Jay Powell? Gavekal concludes with a grimly humorous suggestion: “The first is to resign and let someone else be the next Arthur Burns.” Powell’s alternatives are hardly more attractive—either he cuts rates in the face of all this stimulus, or he braces for 18 months as Trump’s “punching bag.” Yesterday, following the Fed’s decision to cut rates by another 0.25%, Chair Powell responded to the question of resignation with a flat, non-plussed “No.” Whichever path he takes, BCA’s long-term outlook remains bleak for overvalued sectors: “the narrowing of the US-Japan real yield differential” signals potential contractions in global liquidity, particularly for superstar tech valuations.

Conclusion: Riding the Red Wave?

For now, markets revel in the red sweep. Stocks are up, the dollar is rallying, and bonds are reeling. But as BCA and Gavekal both suggest, this celebration is perched on a precipice. The Fed’s balancing act is under increasing scrutiny, Japan’s policies could shift with little warning, and China’s looming “bazooka” could tip the scales at a moment’s notice. For investors, this is no time for complacency—it’s a time to question just how sturdy the ground beneath really is.

Thank you for reading! The links to the two reports are below.

1. Gavekal Research, “Feeling sorry for…”. https://iando.s3.ca-central-1.amazonaws.com/Gavekal_Feeling+Sorry+For_20241107.pdf

2. BCA Research, “Trump Wins, But The Market Reaction Is Not What It Seems”. https://iando.s3.ca-central-1.amazonaws.com/CPT_WR_2024_11_07.pdf