Keep the Wheels on the Cart

President Trump's cabinet is outlining a radically different economic order with three areas that can see the U.S. slide into a growth panic or proper recession as early as the second half of this year. The market remains completely oblivious to all of this.

A key goal is to create jobs and secure supply chains by revitalizing American manufacturing, which they attribute the decline of to a strong dollar, though are not looking to use FX intervention as a primary tool. Instead, the preferred strategy is to "speak softly and carry a big stick" - negotiate by offering access to U.S. markets and the U.S. security umbrella with weakening the dollar as a next resort. Their vision involves the imposition of higher tariffs not only as a negotiating tool, but as a means of financing budget deficits. A permanent tariff wall and looming FX interventions suggest the potential for enormous market volatility, but that is hardly the only thing that can induce a material downturn.

A more restrictive immigration policy - even one falling far short of its impressive goals - would prove very disruptive to the U.S. labor market in the near term. Understanding where employment goes next comes down to thinking about what three years of a red hot labor market (read: three years of reckless immigration policy and inflated statistics) will do when it inevitably cools off.

A priority made clear by Trump, and perhaps the most important key to the credibility of his populist rhetoric, is to reduce inflation. Scott Bessent seeks to recalibrate the composition of the deficit to more closely match the Treasury's pre-Covid goals, which would be very disinflationary in risk assets like equities and would dampen activity in business sectors that are sensitive to interest rates (such as homebuilders).

Each of these, or some combination of the three, will effect an economic decline that can arrive as early as the second half of this year. The stock market remains in wait-and-see mode with tariffs, the bond market doesn't expect Scott Bessent to change Janet Yellen's issuance profile and the Fed continues to assert they will cut rates only twice in 2025. There's plenty of money that will be caught offsides, and at least three ways for it to happen.

- Mike on X

The Tariff Wildcard

Trump has for decades argued in favor of protectionism and sought to reshape global trade to the benefit of the U.S. and, given that these four years are his last opportunity to do so, it's better to take him at his word. Having learned from 2017-2021, he's assembled a loyal team best fit to implement that vision. Aside from supporting employment and domestic manufacturing, there are at least two reasons for why we can expect Trump to levy higher and more aggressive tariffs than he did during his first term:

1. As an explicit source of revenue: Tariffs collected $75 billion in 2019, which would be laughable for an administration wanting duties to finance nearly a trillion dollars in tax cuts and subsidies. This time, however, Trump has explicitly called for tariffs as a means of financing the Federal budget, a policy not very relevant since before the 1913 income tax and one that will demand a broad tariff wall regardless of negotiations.
2. National security: A nation that is, for example, 100% reliant on global supply chains is one that is extremely vulnerable to national security risks. Advances in AI and geopolitical tensions have made supply chains meaningfully different, more vulnerable and more critical since 2020 and Trump's first term.

There's a difference between tariffs designed to collect revenue & finance the most ravenous government in history, and tariffs intended to be a tool for the President to use in his negotiations with a foreign power.

The latter, called "Section 232 tariffs", can be imposed at the stroke of a pen, so long as they're under the pretense of national security. Trump attributed yesterday's announcement of tariffs to combating the opioid (fentanyl) crisis, which days earlier he formally declared an emergency:

A broad wall of tariffs designed to collect duties on all U.S. imports and finance the budget, on the other hand, are "Section 301 tariffs" and would require a more lengthy legal process that could take several months (i.e., around mid-to-late 2025; Howard Lutnick says April 2025) to formally install.

The market seems to perceive tariffs as largely of the "Section 232" kind - negotiating tools, which are not nearly as disruptive as broad, permanent tariffs because said negotiations are supposed to make progress and walk them back. Negotiating tools are negotiating tools. The reason for the benign outlook is probably thanks to the consensus that Trump wants to be a stock market-positive President, which may be true and likely is.

But yesterday, Trump confirmed that tariffs will be deployed regardless of the outcome of negotiations, predictably sending stocks into a tailspin as certain supply chains (and hence products) are left to anticipate and price in irreconcilable, elevated costs:

Of course, a broad tariff wall is the only way to make an 'External Revenue Service' anything more than a political gimmick. It's very unlikely that an ERS would completely replace the dreaded IRS, but don't doubt it making a meaningful change to the way the government funds itself over the next several years.

In any case, the coming tariffs are much more likely to cause higher unemployment, slower economic growth and worse business sentiment than stoke high inflation. Though both should be similarly disruptive, the market is much more anxious to dump equities on account of a recession than it is because the Fed is on hold for a little longer, which is already priced in.

One important thing to note about tariffs, as the market expectedly appears to anticipate higher inflation, is that they are not necessarily inflationary for consumer prices because their impact can be mitigated by currency strength and business margin compression.

One potential outcome in a tariff scenario is for an exporter to lower prices such that the post-tariff price is unchanged for importers. The consumer at the end is not affected by the tariffs at all. The exporter would only be willing to do this when his currency (i.e., the Chinese yuan) has depreciated against the importer’s currency (i.e., the U.S. dollar). For example, an exporter cutting prices by 7% in dollars could be offset by a 7% appreciation in dollars such that his home currency profit is unchanged:

A different scenario that also doesn't raise consumer prices is for the price impact of tariffs to be absorbed by the importer rather than the exporter. Here, the importer pays the same prices and also pays the tariffs, and doesn't pass on the added cost to consumers, compressing their margins. The NBER looked at China and found that this is what occurred in 2018, where after looking through the pricing data of around 100,000 products mapped by their origin and tariff status, the overall data made clear Chinese tariffs had a very limited impact on consumers prices (aside from some examples such as washing machines).

It makes sense that the importing business would absorb the cost of the tariffs if the economy is slowing down.

Along with not necessarily being inflationary, rekindling a trade war with China will dampen business investment and expectedly have a negative impact on certain export sectors, slowing growth. A Fed memo from September 2018 expressed concern on trade policy uncertainty dampening business investment, and suggested it was masked by enthusiasm for Trump tax cuts.

recently declassified memo, the Fed feared that Trump's protectionism would slide the U.S. economy into a period of sluggish growth. They had no concern over the tariffs being inflationary.

It's not only importers whose margins are at risk, but exporting sectors (like the agricultural industry) have suffered from retaliatory tariffs and were forced to reduce prices. The targeted U.S. exports were largely commodities that could be sourced elsewhere, while U.S. imports from China were goods that were more difficult to substitute.

Tariffs pose a much greater threat to full employment, business optimism and growth than they do to price stability and inflation. The second Trump administration is not even two weeks old, but their intent to fundamentally reshape global trade has already been made clear, and tariffs will be play a major role in doing so.

Labor Hangover

President Trump looks to throttle and reverse the historic levels of migration and asylum seekers that have entered the United States illegally and legally over the last few years. The unprecedented influx of migrants under Biden crowded out the labor market (making for some absurd payrolls numbers), put downward pressure on wages and upward pressure on inflation. Even if we assume that mass deportations are going to fall short of "millions" and instead rise to levels seen with Obama of 500k/year focused on criminals, a newly-restrictive southern border will create upward risks to unemployment in the coming year.

For most of 2023, we seemed to get one joke payrolls number after another. The estimates themselves of whether we'd see +350k payrolls or +325k felt silly and awkward to even consider. What the White House celebrated as a testament to the wonders of the "Bidenomics economy" was in reality, along with government hires and reckless fiscal stimulus, a traitorous and duplicitous policy of keeping the border as open as possible, effectively a means of importing cheap labor. I don't think anyone seriously disputes that.

Some of you may recall last June when the Biden administration, facing historic unpopularity during an election year, made policy decisions to tighten border security - ironically undoing actions it had taken just a year or two earlier. Those restrictions are already showing up in fewer southern border crossings:

The FT notes that these actions, along with additional measures to slow immigration, will soon manifest as a shrunken labor supply:

"It takes around six to nine months for new immigrants to officially hit the workforce. Which means that president Biden’s decision should show up in shrinking labour supply soon. ...this action alone will knock off 750k from labour supply (in 2025). Moreover, (Trump is) likely to put in place other measures to slow down immigration, as he has promised.

"This means that US labour supply from immigration will rapidly go back to the averages of the Trump term — around half a million new workers a year. That’s a massive drop-off from the 2mn-plus of the last three years."

The number of jobs created in an economy is a function of both the demand for labor but also the supply of labor - the supply of the people seeking to work for a reasonable wage - which make fewer border crossings meaningful as far as the data is concerned. Unlike other countries, the recent surge in migration has largely been mostly been illegal so the exact number is unknown, but probably at least several million.

Illegal migrants bypass the skills-based legal filters typical in other countries and tend to be lower skilled. Many of the illegal migrants are poorly educated and poorly assimilated (e.g., do not speak nor understand English), which make them particularly vulnerable to unemployment in the event of an economic downturn. The effect of migrants being less employable than native citizens has been observed across other OECD countries, like Canada and Australia, but the share of illegal migrants is uniquely prominent in the US.

A mildly weakening labor market was a canary in the coal mine for the Fed last year, who used it as a pretense to cut rates while keeping some facade of seriousness, but an unexpected weakening in the labor market has long been feared should it warrant many, many more cuts.

Bessent vs. the DOGE

The stated purpose of the DOGE, the so-called Department of Government Efficiency, is to reduce wasteful spending and eliminate unnecessary regulations. It's now mainstream to acknowledge that inflation is a not only a product of government spending but especially one of wasteful government spending.

It's been loud and clear since the election that Federal waste is on the chopping block:

And make no mistake: cutting $1 billion in waste per day from the Federal budget (as the DOGE claims) by slashing DEI, thwarting unnecessary hires and other changes should be celebrated. All of that is unproductive spending, which ought to be the definition of inflation.

But for the DOGE to cut $2 trillion from the Federal budget over the next decade is, as Musk himself put it, "a long shot." Trump's team has indicated multiple times that slashing social welfare programs like Social Security & Medicare or entitlement programs like Medicaid - the krux of the entire budget - are not going to happen.

This is why, in my opinion, the DOGE's true purpose to deliver the message of fiscal responsibility more readily and to a wider audience. That's because the effect that a deficit has on inflation is confusing, and really depends on the composition of the deficit, which is within the purview of the Treasury.

Taking a step back, recently-confirmed Treasury secretary Scott Bessent actively helped define a plan inspired by the “three arrows” of Abenomics:

• 3% real economic growth (real means excluding inflation);
• reduce the deficit to 3% of U.S. GDP;
• a marginal increase of 3 million barrels in daily oil production.

His goal is an ambitious one to say the least, of course facing a fair share of derision. But to Trump, all of that is meaningless should it fail to bring down inflation. And to that end, much more importantly than the programs DOGE will recommend cutting, Bessent has also suggested undoing Yellen’s strategy of ATI, or Activist Treasury Issuance, also appropriately known as stealth QE:

There's a lot of misconception when it comes to the deficit and how it is inflationary. To put it one way, all deficits are inflationary, but some deficits are more inflationary than others. A deficit that is heavily reliant on Treasury bills - very short-term securities maturing in one year or less - is usually reserved for emergencies and/or recessions (when the goal becomes re-inflating the economy out of a deflation panic and high unemployment).

Or, if you're Janet Yellen, it's reserved for juicing asset prices:

November 2023 TBAC report supported a "meaningful" increase in the bill share of the debt, sparking an incredible bull run that hasn't ended since.

It's not a coincidence that the 15-month old, white-hot equity rally began on that day. The weighted average maturity (WAM) of the debt sat at 71.4 months which, after comments from TBAC, the market expected to decline further as the share of bills was expected to remain high for the foreseeable future:

November 2023 TBAC Presentation: Treasury indicated that the pace of coupon (longer-term USTs) auction sizes would not increase, allowing for bills to do so and lowering the WAM in the process.

Think of the WAM as just meaning the average maturity on the debt issued by the Treasury. Start increasing the size of long-dated Treasury auctions and the WAM will increase; issue a flurry of short term debt and the WAM will decrease. That's why the Great Recession and Covid saw sharp drops in the WAM - both crises were funded with bills.

If it were to issue $100 in 6-month Treasury bills and $100 in 2-year Treasury notes, the WAM would sit at 15 months (the average maturity of every dollar). If it were to then begin issuing $100 in 10-year Treasury bonds, too, the WAM would increase to 75 months. In reality, the Treasury's debt profile is much more complex across numerous different maturities, and the 'optimal WAM' is determined by a variety of internal models like the Optimal Debt Model:

Optimal Debt Model" favors issuance to be focused in the "belly" (5-7 year Treasury notes) of the yield curve. There are problems with issuing more bills and there are other problems with issuing more bonds.

The reason bills are so positive for assets is because the market can easily digest them. All Treasuries are money, but Treasury bills carry no duration risk. Duration risk is a concept mostly beyond the scope of this article, but think about it as the opportunity cost of holding debt. In simple terms, the longer the maturity, the greater the risk that rising rates will erode its value. Bills mature within a year, sometimes with maturities as short as a month or less. More capital is required by the private sector for it to take on more duration risk, which in practice means they sell assets (like equities).

What I'd expect from the Treasury's next Quarterly Refunding Announcement on Wednesday are hints that Bessent is indeed seeking to normalize the bill share back down to 15-20% of the debt. That should keep yields elevated without driving too much volatility in his first days. Bessent himself said it would be a gradual process, but it is one that will slow down the rate of inflation.

Keeping bond yields higher-for-longer is key to bringing inflation down, but looks to slump the U.S. into a recession within a year especially if the aforementioned factors also come to fruition.

What does all of this mean?

A broad tariff wall, Trump's policy goal of restricting immigration and a potential move by Scott Bessent to change the debt profile will tighten financial conditions more meaningfully than Janet Yellen and the Biden administration tolerated. All this lays out a clear path to a growth slowdown in the near term, one that may arrive as early as the second half of the year. That will be negative for risk assets (stocks) and could even be recessionary. It will also greenlight more rate cuts by the Fed than the two they sketched out for 2025, something I'll describe in a follow up article.

It's important to realize that we are currently living in a period of great change where the status quo will continue to see enormous upheaval. This means the future will not look like the past, and models built on past relationships that have historically worked no longer will.

To quote Zoltan Pozsar, "So keep an open mind, or get financially repressed."

- Mike on X