The Promise and Peril of the Trump Trade

Long-term interest rates have risen sharply on his pledge to bolster the economy—but can he deliver?

By Justin Lahart

President-elect Donald Trump has made a lot of big promises. If he fails to deliver quickly on the economy, his biggest promise might be a bust. Photo: Getty Images


Markets are predicting that President-elect Donald Trump will be able to juice the economy soon after he gets in office. That is putting extra pressure on him to succeed quickly before higher rates quash any economic liftoff.

Since the election, investors have embraced a view that the spending and tax-cut package Mr. Trump is promising will both boost growth and fan inflation. That has been good for stocks, but very bad for bonds, which have sold off sharply. The yield on the 10-year Treasury note is approaching 2.5%.

Data Tuesday about rising labor costs coupled with last week’s 4.6% unemployment rate mean inflation, and yields, could rise further.

Rising interest rates change the longstanding dynamic in the economy and markets. The higher yields go, the more costly it becomes for companies and households to borrow. The higher yields go, the stronger the dollar is likely to become, widening the trade deficit and weighing on the economy. And the higher yields go, the more attractive bonds become relative to stocks.

If growth is accelerating, higher rates won’t matter to investors and businesses eager to cash in on the stronger economy. But if the Trump trade, which has already driven up 10-year Treasury yields by nearly a full percentage point, proves a mistake, or even just premature, higher rates and everything that comes with them could actually slow growth.

A simulation that forecasting firm Macroeconomic Advisers ran for The Wall Street Journal shows what happens if Treasury yields rise further, not because of an improving economy but because investors believe, based on an incorrect growth forecast or for whatever reason, that the Federal Reserve will raise rates more aggressively. The firm’s econometric model, which incorporates hundreds of variables, is widely used on Wall Street and elsewhere to test economic scenarios.

The starting point assumes that growth doesn’t pick up and current trends persist, with economic growth averaging about 2%, around where it is now, the unemployment rate keeps drifting lower, inflation firms and the Fed gradually raises rates.

If 10-year Treasury yields rise by another half-a-percentage point, then the simulation predicts that annual economic growth by the first quarter of 2018 would fall to just 0.9%. That would push up unemployment, keep inflation lower than the Fed’s target and force the central bank to reverse course and lower rates.

If yields rise a full percentage point, the outlook is so bad under this simulation that the Fed cuts rates down to zero.

But if the Trump trade turns out to be right and the economy picks up, then the simulations show that yields could rise much further without hurting growth.

Borrowing costs would go up, but so would the ability of companies and households to pay their debts, as sales and incomes rise. Companies that spent years selling long-term debt at low rates would benefit. The dollar might rise further, as overseas investors moved to take advantage of Treasurys’ higher returns. That would worsen the trade deficit, weighing on growth, as well as crimping the profits U.S. multinationals generate overseas. But that could be more than offset by a stronger domestic economy.

The stock market would be able to handle the higher yields, as well. For years, the return that investors demand for holding stocks relative to the returns available on Treasurys—what is  known as the equity-risk premium—has been unusually high, reflecting worries that the economy is stuck in a slow-growth, low-inflation environment. An improved economy would ease those worries, allowing stocks to absorb higher rates without falling.

Mr. Trump has made a lot of big promises. If he fails to deliver quickly on the economy, his biggest promise might be a bust.

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