Are Trump's golden ideas starting to lose some lustre?

‘Gaz-a-Lago’: the new Mar-a-Lago

US Treasury yields declined over the past week, on talk of a mini-growth scare, relating to a drop in consumer sentiment. With stocks and crypto assets also retreating, 10-year yields are at their lowest levels since December, with futures curves now back to pricing two Fed rate cuts for 2025.

We are inclined to see growth concerns as overdone. DOGE cuts are leading to job losses in programmes that have been dependent on Federal subsidies. In sectors such as the arts and aid & welfare, some impact may be felt relatively quickly. However, any redundancies that see employees paid for the next six months will only show up in payroll figures at the end of Q3.

Elsewhere, jobless claims continue to show a labour market that remains broadly healthy and, as the administration clamps down on immigration, this is a factor that can lead to a tightening in that market, as the growth in the workforce stalls.

This week also saw the US Budget pass in Congress. This rolls past Tax Cuts and Jobs Act (TCJA) tax cuts, as expected, in addition to outlining cuts in government spending. Looking at the figures, using CBO estimates as a baseline, our own analysis would see this outcome delivering a Federal Budget deficit of around 6.5% in 2025 and 2026, which is broadly the same as in 2024.

In this case, fiscal policy is neither adding to nor subtracting from growth this year, though debt levels will continue to climb under this administration. The main risk to the deficit would come, were the economy to slow. This would lead to a drop in tax receipts, whilst adding to spending. Moreover, we don’t see scope for Trump and Musk to get the fiscal deficit to 3% as they might want to claim, unless Treasury funding costs drop back towards the 1% level seen several years ago.

However, with Treasury funding costs still rising as maturing low coupon debt is replaced with higher coupon debt or Treasury bills, the interest rates expense of debt in the US is still on a rising, not a falling, trajectory. Given that we see Trump policies adding to inflation, rather than subtracting from it, the reality of a world where rates stay higher for longer means that debt expense will weigh on the fiscal accounts for the foreseeable future.

In this context, we are pre-disposed to fade the rally in Treasuries. However, for the time being, we think it makes sense to be patient, in the hope of entering short duration trades at slightly more attractive levels.

Meanwhile, the US stance on foreign policy continues to be met with dismay across many other capitals in the West. Indeed, it was notable that for the first time since 1945, the US sided with Russia on a UN security resolution, in opposition to former European allies.

As attitudes towards the US readjust materially, it may be interesting to see if this has a bearing on the demand for the dollar and US assets in general. We have already seen how central banks are diversifying reserves away from the dollar, and geopolitical concerns may only accelerate this trend.

At a time when the US runs a current account deficit, it is dependent on attracting overseas capital in order to offset this flow. However, if the US cannot be trusted, then the incentive to own the USD may be called into question more.

Although US growth exceptionalism and tariffs are a reason to expect a stronger dollar, valuations and geopolitical concerns with respect to the US are factors that could work in the other direction. Consequently, we have been reducing our enthusiasm for the greenback, reducing positions that benefited performance during Q4 2024.

Last weekend’s German election delivered a largely expected result, with Merz set to become the next Chancellor in a CDU coalition government with the socialist SPD. Although the right-wing AFD grabbed second place, there was some relief that their vote share failed to surpass opinion poll projections.

If there has been any sense of political surprise in recent days, it has been a more assertive push by Merz to secure agreement on a large increase in defence spending, in light of calls for the EU to ensure its independence from the US. Consequently, it appears that Merz is now open to sanctioning part of a defence spending increase via joint EU issuance, outside of national budgets.

He has also pushed the idea of recalling the existing German government in a lame duck session, in order to agree a constitutional change to allow for increased spending by amending Germany’s debt brake. This would require a two-thirds majority in the Bundestag, which will be difficult to achieve once the new government is in place, due to a blocking minority from left-wing and right-wing populists.

Across the EU, proposals being circulated infer a cumulative EUR500 billion increase in defence spending over a 3-year view, bringing spending close to 3% of GDP across the bloc. Funding for this may be approximately equally divided between EU issuance, ESM/EIB issuance, and national debt issuance, with any increase in the latter exempted from EU Budget rules. Inasmuch as this sum would represent a net fiscal easing of around 1%, then this will lift GDP in the region.

However, there remains a question of how quickly any of this may be seen in practice. For sure, it may be relatively easy for Rheinmetall to switch its production from civilian to military consumption. However, it will be more rechallenging to re-tool in other areas, and those familiar with business practices in Germany will understand there will be plenty of bureaucracy, administration, and red tape to be cleared in the interim.

There is also a question around additional spending – how much will actually be new spending on defence and how much is existing spending, which gets moved into a defence budget. This is something that the US, in particular, will be very attentive to. From a Trump perspective, the military needs more soldiers, not diversity or climate change analysts!

With respect to fixed income yields, additional defence spending will mean more government debt supply and also somewhat higher growth, limiting the need for the ECB to lower interest rates. Noting the more hawkish stance coming from ECB’s Schnabel, we see Lagarde cutting interest rates once or twice more this year, before rates are on hold.

In light of this, we suspect it will be difficult for bund yields to rally too much, unless there is a much more pronounced economic downside risk evolving – such as may be possible in light of potential US tariffs. Prospects for an increase in EU issuance has seen us exit existing exposure from the issuer, on the risk that new supply could lead to a re-pricing of spreads.

However, we would broadly view joint issuance as a step in the direction of closer euro integration and, from this perspective, we see this as a largely constructive development for Eurozone spreads. This leaves us more favourably disposed towards Italy BTPs. However, at a valuation of 110bps above bunds, it is hard to argue that Italy is particularly cheap, and we are more inclined to look to add, should market volatility lead to wider spreads levels at some upcoming point.

The UK is also being challenged to raise its defence spending but is struggling to find room in its Budget. The government heralded the largest increase in defence spending since the end of the Cold War this week, although the actual Budget is only budging from 2.3% to 2.5% of GDP over the next two years.

Moreover, the UK has classified its Intelligence Budget within the Defence budget. It may also appear that foreign aid payments – such as the disastrous compensation payment to Mauritius for the Chagos Islands, in which Starmer seems oddly committed, to funnelling funds to Chinese friends, against the wishes of Washington and many UK taxpayers, is also included in ‘defence spending’. This won’t go down well with Trump, and it seems that past mismanagement of the British armed forces has gutted its manpower and fighting strength, in favour of soft power and ‘progressive’ initiatives.

Looking at the defence budget, this just serves to highlight the troubled state of UK government finances. There is no money to spend. Raising taxes further is leading to declining tax revenues and the government seems unable or unwilling to curb excessive government spending in the belief that it has to prioritise public services.

Meanwhile, with UK energy prices set to rise by 6.4% in April, the news on inflation continues to get worse, whilst the growth outlook remains depressed. Stagflation fears are a reason to be wary on UK assets and the pound, and we would look to short 10-year gilts close to 4.40%.

Economic data in Japan have continued to be upbeat over the past week. Department store sales growth accelerated to 5.2%, whilst producer prices were up slightly at 3.1% year-on-year. However, JGB yields moved lower, in line with other markets. Sentiment was also supported by BoJ comments that they would step in to stabilise the market, having seen yields moving nearly 50bps upwards in a straight line since the end of October.

However, we take this as a statement that the BoJ wants to smooth, rather than reverse, the recent trend. In this light, we continue to see 10-year rates settling in a range between 1.5%-1.75% later this year. In the short term, we see greater opportunities with respect to the yen. Over the past few weeks, the Japanese currency has outperformed as rate differentials have been narrowing, and we see plenty of scope for this trend to run further, over the course of the months ahead.

Looking ahead

Given recent question marks over US growth, this will mean that there is elevated scrutiny in the upcoming data roundup at the start of March. Meanwhile, the March 4th deadline on Mexico and Canada tariffs is just around the corner, and we will also be focussing on the upcoming EU Leaders Summit.

Broadly speaking, we feel that the decline in yields in the past week is unjustified, and this leaves us leaning towards a short duration stance if yields continue to go much lower. In this context, gilts may be the most attractive short, as we just can’t see the BoE able to cut rates given the inflation backdrop.

With concerns over UK government finances, we think it will thus be hard for gilt yields to rally much below the cash base rate at 4.50% and on this basis, gilts may offer an attractive return asymmetry. However, we would like to get some of the short-term uncertainty out of the way, and we continue to reflect that positioning can continue to be hostage to tweets and Trump-dominated headlines.

In Ukraine, headlines suggest that a peace deal may almost be within reach, with Kyiv reaching an agreement with Washington in terms of developing the country’s natural resources. With Russia, as well as Ukraine, motivated to cease fighting, a breakthrough may appear within sight.

However, we would continue to caution that any ceasefire, which is agreed, could prove to be fragile and short lived. Many commentators will worry that, having created a precedent, aggressors can achieve lasting territorial gains. They will question whether Russia’s longer-term aims will see it renew conflict at a time of its choosing, once it has been able to rebuild its arm back close to full strength, which may not take too long with the country ploughing 8% of its GDP into its defence budget. This assessment has meant we have become more cautious on the outlook for Ukrainian assets.

In the universe of stressed sovereign debt, we currently see more upside opportunity in Lebanon and also Venezuela, though these are names we would only be inclined to invest in within dedicated EM debt strategies. Admittedly, including a name like Venezuela in a list of upcoming opportunities may seem surprising. Though with Donald Trump half channelling his inner Kim Jong Un, (based on images from the questionable Trump Gaza video released this week), you half wonder when North Korea will emerge as a market we are considering!