When Donald Trump pulled off a surprise win in the 2016 presidential election, the news ignited a powerful rally in the U.S. stock market that lasted into early February 2018.
During that 15-month span, both the S&P 500 index and the Nasdaq Composite index posted gains of 30 percent or more. News stories at the time proclaimed that Trump’s pro-growth strategies that embraced tax cuts and deregulation had unleashed “animal spirits” among investors.
Immediately following Trump’s win in the 2024 election, the same phenomenon appeared to be taking place, as the U.S. stock market posted strong gains in November and into December. The rally has stalled so far this year, however, leaving investors less confident of what lies ahead.
The stock market rally’s pause has been linked to a surge in U.S. Treasury bond yields of a full percentage point since the Federal Reserve began easing monetary policy at the September Federal Open Market Committee meeting. Some observers believe the yield on the 10-year Treasury could reach the 5 percent threshold, which would be the highest level since 2007.
In the process, the Treasury yield curve has become positively sloped for the first time since 2022. The so-called “term premium,” which measures the compensation investors require for bearing the risk that interest rates may change over the life of a bond, is also positive now. It reflects investor uncertainty about the outlook for inflation amid large federal budget deficits and prospects for hikes in tariffs.
A Wall Street Journal article observes that “bear steepenings” following inverted yield curves are rare, and they are mostly reminiscent of the stagflation environment of the 1970s and early 1980s.
So, what is behind the recent developments in the stock and bond markets?
The most common explanation is that investors have been lowering their expectations for Fed rate cuts in response to better-than-expected economic news. In late September, the Treasury market was pricing in cuts in the funds rate of a full percentage point or more in 2025. Now investors are expecting only one or two quarter-point cuts in the wake of the strong jobs report for December, and some are wondering if there will be any cuts.
Beyond this, a shift may be taking place in the way investors view the economic landscape today versus the environment during Trump’s first term.
At that time, the U.S. economy was in the throes of a sub-par recovery from the 2008 Financial Crisis, inflation was dormant and 10-year Treasury bond yields fluctuated in a narrow range centered about 2 percent. Amid this, Trump’s top priority became the Tax Cut and Jobs Act that was enacted at the end of the year, which fueled the post-election rally in stocks.
By comparison, Trump is inheriting a much stronger economy now. It is estimated to have grown at a 2.8 percent rate last year while the unemployment rate ended the year at 4.1 percent. With the economy operating near its long-term potential, investors are concerned that the federal budget deficit in excess of 6 percent of GDP is too large.
The goal of Trump’s designated Treasury secretary, Scott Bessent, is to cut the deficit in half. However, this will be challenging considering that Trump wants to extend the Tax Cuts and Jobs Act for another 10 years and mandatory programs account for about 70 percent of total federal spending. Accordingly, bondholders are now seeking more compensation for the risk they are taking.
The biggest cloud hanging over the stock market, however, is what Trump will do on the tariff front to narrow the U.S. trade deficit. During his first term, he waited until 2018 before he tackled the trade issue when he boosted tariffs on select imports from U.S. trading partners and then undertook more significant action against China. Amid this, the stock market turned volatile and at one point sold off by about 15 percent before a U.S.-China truce was reached in mid-2019.
Since then, the U.S. current account deficit has doubled from 2 percent of GDP to 4 percent of GDP. Moreover, it is expected to widen further as the U.S. economy outpaces Europe and Japan, while China has been pumping out exports at a rapid clip. The U.S. dollar has also been unusually strong in the past two years and is approaching its all-time high in the mid-1980s, which will make it more difficult for U.S. companies to compete internationally.
In response, Trump appears determined to move quickly to put pressure on trading partners to narrow their trade surpluses with the U.S. But there is considerable uncertainty about how he will proceed.
The Washington Post reports that Donald Trump’s aides are exploring tariff plans that would be applied to every country — so-called “universal tariffs” — but that would only cover critical imports. If implemented, they would pare back the most sweeping elements of Trump’s campaign plans but would still carry major consequences for the U.S. economy and consumers. They would also be in addition to actions Trump has announced he is prepared to take against China, Mexico and Canada.
Meanwhile, Bloomberg reports that Trump’s advisors are studying a phased approach to unveiling tariffs in which there could be monthly increases of 25 to 5 percent, rather than a larger one-time increase in tariff rates. The goal would be to do so as a way to pressure countries to take strong action while containing some of the economic fallout.
Amid this, the big unknown is how far Trump is prepared to go to win a trade war before it winds up crushing animal spirits.
Nicholas Sargen, Ph.D., is an economic consultant for Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has authored three books including “Investing in the Trump Era: How Economic Policies Impact Financial Markets.”
