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What will curb Donald Trump? Right now, as European leaders agonise over how to respond to his aggression over Greenland, it’s hard to plot a positive course of action.
Retaliate on his tariff threats? Yes, the EU could do that, but it would hurt Europe as much as America. Beef up Denmark’s military presence in Greenland with other European troops? They had a go at that, but it seems to have enraged the US President even more. Press on with reasoned arguments, coupled with a charm offensive? Doesn’t work, and you simply humiliate yourself.
There is, however, one weakness in the Trump administration’s armoury. It is the US fiscal deficit. This gap between what the government is spending and what it is raising in taxation is running at more than 6 per cent of GDP. There are not enough savings in America to cover it. So foreign investors have to carry on buying US Treasury debt to keep the country afloat. If they stop, or worse, start selling, their existing holdings in significant long-term dollar bond yields rise. That’s not only the interest that the government has to pay, but what all dollar borrowers have to stump up: companies, home-buyers and so on.
While for a period the US Federal Reserve can keep funding the government by issuing short-term debt – in effect printing the money – that has the effect of increasing inflation and probably undermining international confidence even more.
The result? Well, we had a mini-version of what happens when international investors lose confidence in a government in September 2022, when Liz Truss and her chancellor, Kwasi Kwarteng, tried to launch a Budget that pushed up the government deficit to a level that the markets deemed unsustainable. There was a run on government bonds, a plunge of sterling on the exchanges and a sharp fall in UK equities. In effect, it was global investors that brought down her government.
Even his detractors would have to acknowledge that Donald Trump is a somewhat more considerable figure than Liz Truss. The US economy is vastly more substantial than the British one, and the market for US Treasury securities is much broader than the market for UK gilts. So the idea that Donald Trump could have a Liz Truss moment does seem outlandish. But the markets – which really means global investors – can and do control the President in more subtle ways.
We saw that yesterday. On Tuesday, US markets had a really nasty day with the main share indices falling by around 2 per cent, wiping out all the gains they had made this year. Then, on Wednesday, Donald Trump declared in Davos that he would not use force to acquire Greenland, whereupon they headed back up. However – and this is important – they did not regain all the losses. So the President’s bombast has cost investors money. He knows that, and they know that too.
Looking further ahead, we should not rule out the possibility that there will indeed be some sort of run on US government bonds. It’s a small signal, but several pension funds in Denmark have started selling their American holdings, and a large Swedish pension fund has done the same.
There is as yet no concerted action by European investors, and the US Treasury Secretary Scott Bessent said that he is not worried about Danish institutions dumping US bonds. He put the point bluntly: “Denmark’s investment in US Treasury bonds, like Denmark itself, is irrelevant.”
However, the argument is not just about Denmark. It is that US assets in general have become more risky both as a result of the President’s actions and of the scale of the country’s fiscal deficit. Prudence, not politics, says you should de-risk and that means you sell. Bessent may not be worried, but the people who hold US bonds clearly are.
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So what will happen? It does not feel as though a full-scale, helter-skelter run on the dollar and on US assets is imminent. That is partly because every time the markets do wobble the President steps back. The underlying financial position of US public finances is dire, but so too is that of most developed countries, including our own. At some stage – no one can know when – the US, along with other heavily indebted nations, will have to cut government spending and/or increase taxes. Meanwhile the size and liquidity of US markets does give the country some protection.
However, we have seen time and time again the one thing that will curb Donald Trump’s excesses is the power of global investors. When it comes to military might or global political clout he is playing a strong hand, and he knows it. When the issue is keeping investors in American debt onside, he is playing a weaker one.
Of course he would never admit it, but from the way he behaves when the markets move against him, it is clear he knows that too.
Further thoughts
It is hard, looking at the extent to which the US dominates global finance, to remember that there have been long periods in the past when the dollar has been in the doghouse and US bonds and equities have been shunned by the rest of the world.
The first example of that post-Second World War was in the late 1960s when pressure built up on the Bretton Woods fixed exchange rate system. Through the early part of that decade it was the pound that was in the firing line, and that resulted in sterling devaluation in 1967. Then pressure switched to the dollar, and despite the dollar devaluation against gold in 1971 under the Smithsonian Agreement it continued until fixed exchange rates were replaced by floating ones in 1973.
The dollar then fell through the early part of the 1970s, propelled by the surge in oil prices and in inflation more generally, before the new chair of the Federal Reserve, Paul Volcker, jacked up interest rates to 20 per cent in 1980 to control surging inflation. The dollar then started to strengthen right through to 1985, indeed becoming overly strong; that led to the Plaza Accord in 1985 to reverse it.
The sterling/dollar rate is not a bad proxy for the extent to which confidence in the two currencies has fluctuated over the years. Though the general trend has been downwards, there have been several periods when sterling has been above $1.75, and one relatively recent one just before the financial crisis of 2008 when it topped $2. There is a graph here that shows the history since 1971. By the way, my target as a sensible long-term rate for the pound against the dollar is $1.50. I expect it to climb to that in the none-too-distant future.
My main point is this. At the moment there is reasonable calm on both the exchanges and the bond markets. It was not always so, and it will not always be so. If inflation starts to move up seriously – or maybe even if it fails to come down to the central bank target of 2 per cent – then the bond markets will react.
If the US performs worse than the rest of the world, then the dollar will be hit. It is impossible to get this right as an investor. So a wise strategy is to spread risk. That is what that Danish pension fund and others besides are doing when they sell some US assets.
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