The ECB amid the reverberations of the Trump Trade

Donald Trump’s victory in the US election has shifted expectations in the financial markets. Already in the first few weeks of autumn, the probability of a victory that was reflected in the betting odds was accompanied by higher interest rates, expectations of a less dovish Fed and a stronger dollar. These dynamics, which were given an additional boost by the strong macroeconomic situation in the US, were compounded by a stock market rally following the confirmation of the triple Republican victory in November (White House, Senate and House of Representatives). In Europe, however, the movements have been more moderate and expectations regarding the ECB remained particularly stable (see first chart). Does this mean that the change of US administration will not affect the outlook for the ECB?

The new Trump administration’s economic agenda includes an expansive fiscal policy (tax cuts), a restrictive immigration policy and barriers to international trade (tariff hikes). By stimulating demand and limiting supply in a context of maturity in the business cycle, these three pillars could trigger higher inflation in the US and, in the short term, moderately stimulate domestic economic activity. As a result of these consequences, which are consistent with the anticipatory market movements mentioned above, the combination of a stronger dollar, higher interest rates and stock market gains has become known as the «Trump Trade».

For the European economy, there are three major channels through which the new administration’s agenda could end up impacting the short- and medium-term economic outlook. Firstly, the proposed tariffs would make exports from Europe to the US more expensive and would cool external demand for the euro area. The appreciation of the dollar could mitigate the negative impact on European economic activity, but at the cost of importing inflation which could be accentuated in the event of a trade war and tariff retaliation on the part of Europe. Secondly, the spillovers of a less dovish Fed (as it combats inflation) could trigger a tightening of global financial conditions, including in Europe. Thirdly, the heightened uncertainty could weigh down investor sentiment and risk appetite, potentially depressing economic activity.

The net impact of these three channels on the ECB’s actions is uncertain: the euro area could suffer some degree of inflation, depending on the intensity of the policies and the reaction of asset prices, as well as the cooling of European economic activity (and its transmission to prices). In addition, there are other uncertainty factors, such as Congress’ capacity for moderation given the tight Republican majority, or the question of whether the Trump administration’s tariff threats are indisputable or, perhaps, a tool for trade negotiation between governments. While we await clearer visibility on all these aspects, the reaction of the financial markets can provide some initial clues.

This exercise, which is summarised in the third chart, indicates that the Trump Trade has a significant spillover effect on the financial markets in the euro area, affecting both short- and long-term sovereign rates and the ECB’s monetary policy expectations and inflation expectations. In all cases there is a positive co-movement with the US (i.e. although the magnitude of the impact of the Trump administration’s agenda is smaller in Europe, according to the financial markets the direction of that impact is the same in both the US and Europe). However, the strongest spillover effect is found in sovereign rates, especially in the longer sections of the curve, while the spillover to inflation expectations is clearly less pronounced. As for monetary policy expectations, the exercise suggests that the markets see a knock-on effect of a moderate magnitude.