July 24:
Election cycle theory suggests that the negative effects of Trump’s tariff policy will not fully set in until the beginning of next year. Thus, we can expect that the stock market will remain on relatively steady footing until then. On the other hand, Trump’s fight with Fed chair Powell has some very negative ramifications. First, Fed policy independence is being threatened by Trump. Firing Powell would send the stock market into turmoil and could cause a complete collapse in the short-run. The longer run is a bit more complicated but rests on the fact that the ECB just decided to keep interest rates the same due to tariff uncertainty.
In the U.S., Fed chair Powell has also kept interest rate reductions on hold due to tariff uncertainty and the increase in the inflation rate that is already underway due to tariffs. Trump still thinks he wants lower rates, however. Here is what happens if Trump gets his way. The Fed only controls short-term rates via the discount rate that it sets directly and the targeted federal funds rate. The discount rate is the interest rate the Fed charges member banks that need to borrow cash reserves to meet their legal reserve requirements on checking deposits. The slightly lower federal funds rate is the overnight rate charged by banks that want to lend their excess reserves to other banks to meet their reserve requirements. Lowering the discount rate causes the Fed to increase excess reserves or monetary liquidity into the banking system so as to reduce the targeted federal funds rate. More liquidity, in turn, pushes up prices and the inflation rate.
In the bond market, the real return on a bond is the nominal interest rate received by the bond holder minus the expected inflation rate. When the expected inflation rate increases due to lower short-term interest rates and increased monetary liquidity, bond holders must demand higher nominal rates so as to maintain the same real return on bonds. Consequently, existing bond holders will tend to sell their existing bonds and drive up the nominal interest rate. This happens because bond values and their corresponding nominal interest rates are inversely related. Thus, short-term rate reductions will increase interest rate expectations and longer term market interest rates in the bond market.
Some consequences of higher longer term interest rates are less private investment by home purchasers and corporations. This will increase unemployment along with the higher inflation rates. I think this is just the opposite of what Trump wants, but it just means that Trump does not understand basic economics.
Given that the economy is threatened by both tariff and monetary policy risks but effected positively by election cycle theory, one can make the argument for investing cautiously until 2026. Some growth stocks to consider are: APEI, PAAS, AU, HMY, KROS, KGC, STKL, B, and FUTU. Dividend growth stocks include: ACRE, APAM, BSET, CRGY, KGS, PAGP, TROW, VOD, and ARLP. For the previous three months, the five fastest growing ETFs were: SMHX, SHOC, SMH, TRFK, and FTEC. As always, good investing!
