Market Update: Trump turns nasty; markets turn nice

It felt like the first week of summer holidays. Stock market volatility dropped again – both in measured and implied terms – and the 9 July deadline on Donald Trump’s tariff moratorium was no deadline at all. The US president pushed back tariff implementation, initially warning 14 countries (mostly in Asia) that they will face higher import taxes unless trade deals are signed by the start of August. Today, he expanded those threats to Europe and Canada.

Calm equity markets pushed up to new highs – in local currency terms at least. In sterling terms, the US markets are not quite so rampant because of the much discussed year-to-date weakness in the US dollar.

The theme of markets’ summer continues to be abundant liquidity. There is plenty of money in the system, underpinning strong investor risk appetite and allowing markets to gently grind higher. We have slight reservations about how long this liquidity might last, but for the moment things look positive.

Bond investors don’t mind UK tax hikes – but stocks might

So, for the second week in a row, the FTSE 100 broke a new all-time high. And for the second week in a row, UK press coverage was more focussed on the negative impacts of potential tax rises. These now feel inevitable and many people will be concerned, but we should not get carried away with some of the more excessive figures floated by the press. Actual tax hikes will likely be lower than the £20bn suggested in some quarters, though they will certainly still be felt.

Capital gains tax (CGT) looks like one of the most likely areas to see an increase, which makes things uncomfortable for investors. Many will likely try to realise gains before higher taxes come in, which could create some short-term selling pressure on UK assets.

The impact on UK stocks might be limited, however. We have discussed before that the UK stock market has a problem with trading liquidity, and a key source of that problem is the fact that Britons are not heavily invested in it. A CGT hike should not mean a big sell-off, then, but on the other hand it certainly does not make the liquidity problem any better.

It is worth bearing in mind that, for global investors in UK bonds, tax rises will be taken as a fairly good sign. They show the government’s commitment to fiscal discipline, which should bring down interest rates. It may be a negative for growth, but it should at least mean bond market stability.

Indeed, Friday’s data showed UK GDP contracting 0.1% month-on-month in May, bringing the average for the last three months back down to zero. Bank of England Governor Andrew Bailey has been hinting at interest rate cuts recently, which probably reflects the Monetary Policy Committee’s stance. Markets continue to expect another rate cut on Thursday 7^thAugust.

Markets shrug off Powell threats

The outlook for US rate policy is less stable. Rumour has it that Federal Reserve chair Jerome Powell might leave his post as early as September, following incessant criticism from Trump over the Fed not cutting interest rates as quickly as he would like. The favourites to take over are Treasury Secretary Scott Bessent, former Federal Board of Governors member Kevin Warsh, and National Economic Council director Kevin Hassett. Of those, Hassett is considered the closest to Trump, and his potential appointment has led markets to lower their interest rate expectations.

That has steepened the yield curve – the difference between short-term and long-term bond yields. Short-term rates have fallen in expectation of sharper cuts, but longer rates have also moved up in expectation of higher inflation. Our measure of government ‘credit risk’ (we compare government bond yields and equivalent length interbank swap contracts) has also edged up. Government bond risk is not just a US phenomenon; investors see government debt everywhere as more risky than it used to be.

This kind of bond move would normally hurt stock prices, as they look less attractive by comparison. That has not happened lately, though.

Investors appear to be backing a positive growth story. The rise in bond yields comes alongside strong performances of banking stocks (which are sensitive to economic growth) and the recent upgrades to US company earnings expectations. A key driver of this optimism, however, is that markets have so much liquidity.

Liquidity helps markets ignore nasty Trump – for now

Trump is acting like his disruptive self again, after a period of relative calm as far as markets were concerned. In the last week, he has sent out tariff letters to multiple countries and imposed a surprise 50% tariff on copper imports – which we cover separately. But abundant liquidity is helping markets see the bright side: tariffs have yet again been delayed, an EU-US deal is imminent, and tax cuts are on the way.

Researchers at CrossBorder Capital recently pointed out that the US treasury has effectively been spending its savings (reducing the Treasury General Account balance) for a long time, in part due to limits from the US debt ceiling. over the past six months, there has been a net injection of about $400bn, which has supported the wider financial system. The chart below shows how the balance has fallen even below the trend level which pertained before the Pandemic.

The debt ceiling has just been raised by US congress from $36.1 trillion to $41.1 trillion, and Trump’s tax cuts will require significant new debt issuance. CrossBorder thinks much of this may be done through short-term bill issuance, and that the US Treasury will probably run a lower overall level of funds, compared to the past two years. Nevertheless, the supportive flow of liquidity from the US government will dampen somewhat – and investors might be less happy to buy risk assets when it does.

At the same time, however, the clear improvement in company earnings expectations shows us that investors are not just feeling good for the sake of it; there are genuine profits to back it up. We just hope growth signals are strong enough to support markets when liquidity conditions are more challenging. If they are, the summer holiday will carry on.