Trump 2.0: Towards Lasting Divergence Between the United States and the Eurozone?

Donald Trump's policies could fuel inflation, widen the gap between US and European interest rates and strengthen the dollar -- a real paradox for the president-elect.

As disinflation gains momentum and the Federal Reserve (Fed) begins to ease monetary policy, the election of Donald Trump risks altering the trajectory of the US economy. While uncertainties remain about the policies he will ultimately implement -- and their timing -- the general direction of his proposals seems clear: They are likely to widen the interest rate spread between the US and Europe and strengthen the dollar.

Trump: An inflationary cocktail

In 2016, bond markets reacted swiftly to Donald Trump's then-unexpected election victory. Within weeks, US long-term yields rose from below 2% to over 2.5%, a rise that German yields only partially followed.[1] The yield spread widened from 180 to 240 basis points (bps). After a brief narrowing in 2017, the spread widened again, approaching 280 bps in 2018.

Eight years later, with a lesser surprise factor in Donald Trump's second election, bond markets seem to be repeating their pattern. This time, the gap between US and German interest rates had already widened before Trump's potential return -- and it has continued to widen. The economic ‘cocktail’ Trump is proposing is enough to unsettle bond investors. The ingredients -- tariff hikes, tax cuts and tighter immigration controls -- are largely the same as in 2016. However, what was once served in a context of low growth, moderate inflation and highly accommodative monetary policy now carries much greater risks, the more since the mix is likely to be more potent this time around:

• Expanded tariff threats: Tariff threats now extend beyond specific Chinese goods to include all imports from China and potentially the rest of the world.
   
• Tougher immigration policies: Plans to deport millions of undocumented migrants could deprive the economy of vital labour in an already tight market.
   
• Reduced fiscal flexibility: The deficit is projected to reach 6.4% of GDP in 2024, up from 3.1% in 2016, leaving less room for manoeuvre.
   
• An economy firing on all cylinders: Unlike in 2016, annual growth is solid at 2.7%, unemployment remains low just above 4% and core inflation[2] has decelerated but is still at 3.3% (compared to 1.8%, 5% and 2.1% respectively eight years earlier).

Towards a sustained divergence in interest rates...

With inflation risks on the rise, the Federal Reserve may be forced to slow the pace of monetary easing.

The Eurozone, on the other hand, could come under increasing pressure to act in the opposite direction. Donald Trump's election could prompt the European Central Bank to accelerate its rate cuts, as weak growth coupled with a potential trade war with the US could push the Eurozone dangerously close to recession.

On both sides of the Atlantic, markets have already adjusted their monetary policy expectations significantly. The Federal Reserve's projected rate for the end of 2025 rose from 2.8% in mid-September to 3.6% on the eve of the election, rising further to over 3.9% three weeks later. Meanwhile, European interest rate expectations for the same period have fallen by almost 30 basis points since the time of the US election, back to their mid-September level of 1.8%. This divergence is further highlighted by movements at the long end of the yield curve, where the spread between US and Eurozone 10-year rates widened by 30 basis points in the brief time between the 5 November US election and 22 November, to more than 200 bps.

In the eyes of the markets, the Republican ‘sweep’ -- Donald Trump's Republican party securing the presidency and a majority in both the House of Representatives and the Senate -- increases the likelihood of a potentially inflationary programme. While the proposed appointment of Scott Bessent as Treasury Secretary may reassure markets about fiscal discipline, other expected appointments to key government positions provide little confidence that the new administration might take a moderate course. This combination of uncertainty about economic and monetary policy and the rising inflation risk premium could lead to an increase in the term premium on US long-term interest rates.

Markets already partly reflect the expected consequences of Donald Trump's election. In the coming months, these expectations will change in response to the measures actually taken across the Atlantic, which could lead to periods of volatility. However, the rates trajectory following Donald Trump's election seems clear: A wide spread is likely to be maintained between US and European interest rates. This yield curve differential could widen further if the new administration implements most of Donald Trump's campaign promises.

... and a strong(er) dollar, for longer

While Donald Trump has expressed a desire for a weaker dollar, the path on which he appears to be taking the US economy is more likely to strengthen it. Indeed, adjustments to monetary policy expectations have already benefited the US currency, which gained almost 5% against the euro in the three weeks following Trump's election, extending a trend that began before the vote.

Fiscal policy could also support the dollar. By reinforcing American 'exceptionalism', measures such as extending tax cuts for households or cutting corporate taxes could provide additional support for the greenback, at least in the short term. However, the uncertainty surrounding the future administration's policies could lead to short-term volatility in the currency.

Potential developments in fiscal policy within the Eurozone could nevertheless mitigate or even reverse the trend between the two currencies. In Germany, for example, the outcome of the elections in February 2025 could lead to a shift in fiscal policy with measures aimed at supporting economic activity. This could lead to an increase in bond issuance, putting upward pressure on German interest rates, which in turn could contribute to the appreciation of the euro.

The implications of the US election for bond and currency markets are clear. However, they present a paradox for the next president. With a tighter-than-expected monetary policy, higher interest rates and a stronger dollar, the programme proposed by Donald Trump during his campaign directly contradicts his desire for low interest rates and a weak dollar. The next occupant of the White House will therefore continue to grapple with the implications of his own economic policies. This could make him even more unpredictable and exacerbate tensions with what he calls the 'boneheads’ at the Fed.[3]

Prices and calculations as of 22 November, 2024.

[1][ Figures quoted in the article, except those shown in the graph, are from Bloomberg.
[2] Inflation adjusted for energy and food prices.
[3]In September 2019, Donald Trump lashed out at Fed officials on Twitter, calling them “boneheads” for not keeping up with ultra-low or even negative interest rates in other parts of the world: https://www.reuters.com/article/world/uk/note-to-trump-negative-rates-have-delivered-few-positive-results-idUSKCN1VW2R7/