Market responses to Trump's second victory

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The election triggered a remarkably powerful demand shock, reflecting markets' expectations of expansionary fiscal policy under Trump's second term. The magnitude of this demand response was striking – exceeding four standard deviations (see figure 3a), a level not seen in the markets for several years. It seems prudent to note that demand shocks in the US have not been truly random in recent months, despite economic news not following this pattern, which may indicate somewhat exaggerated market optimism.

The Federal Reserve's response added another dimension to market movements. Following Trump's victory, Fed officials' communications took on a rather hawkish tone, going beyond what would be expected as a mere reaction to anticipated stronger economic demand. This hawkish stance from the Fed (figure 3b), which also reflected central bank’s signals to defend its independence and credibility, played a role in strengthening the dollar too.¹

The key divergences between market responses to Trump's first and second elections stem from two primary factors:

1. A pronounced shift in global risk sentiment emerged. Political instability, particularly the collapse of governments in Germany and France (see figure 3d), triggered a broad movement toward risk aversion. Such environments typically drive investors toward safe-haven assets like government bonds, naturally pushing their yields lower.
2. A significant transformation occurred in oil market dynamics. The Israel-Lebanon ceasefire catalysed a positive supply shock in oil markets (see figure 3c), leading to lower inflation expectations and, consequently, declining government bond yields.

This market environment stands in contrast to the conditions following Trump's first election, which featured a risk-on sentiment globally and negative supply shocks in oil markets. While both factors have shaped current market dynamics differently than in 2016, their impact on the dollar has been similar (see figure 1b). Since the US is an oil exporter, lower oil prices naturally reduce dollar demand. However, this effect has been offset by increased safe-haven demand for dollars during this period of heightened risk aversion. The result is that, despite different underlying drivers, the dollar's trajectory has closely followed the pattern seen after Trump's first victory.

Particularly noteworthy is the market's response to proposed immigration and trade policies. While pre-election analysis emphasised potential negative supply shocks – less than in 2016 – these concerns haven't materialised. Instead, the initial weeks showed positive supply responses, despite rhetoric around immigration restrictions and trade tensions. This raises questions about market interpretation of these policies. The strongest positive supply signals emerged after Bessent's Treasury Secretary nomination on November 22 (see figure 3e). Though Bessent supports certain tariff measures, his more measured approach compared to Trump may suggest to markets that any tariffs will be targeted and limited in their inflationary impact.

In Figure 1b, we also observed the dollar's decline after Biden's election. While some interpreted this as scepticism toward Biden's economic agenda, the movement primarily reflected improving global risk sentiment and accommodative monetary conditions following the pandemic. Positive demand shocks were measured, though less pronounced than those following either Trump victory.

Technical Methodology

Our analysis employs a structural BVAR model using daily data from 2015, incorporating the S&P500, USD index, oil prices, USD 5-year inflation-linked swaps, and 5-year government bonds. Shock identification relies on sign restrictions, building on frameworks from Höynck (2020)² and Ricci (2024)³. We identify demand shocks through consistent directional responses across variables. Supply and oil supply shocks both boost equity prices while reducing inflation expectations, though their oil price impacts differ. Given US oil export status, positive oil supply shocks typically weaken the dollar. Monetary policy shocks inversely affect government bond prices while boosting equities, inflation expectations, and oil prices. Risk-off scenarios typically reduce yields, depress equities, and strengthen the dollar.

Conclusion

Our fundamental decomposition of market responses to Trump's second victory shows that it echoed his election in 2016 - especially in boosting expectations for stronger US domestic demand. On the other hand, the déjà vu has been incomplete because of distinct global conditions – particularly Middle Eastern developments and European political uncertainty. These external circumstances probably prevented similar bond yield increases. Moreover, contrary to initial predictions, the interplay of the key US markets have indicated that negative supply shocks haven't emerged. In this respect, it seems that the US treasury secretary nomination of S. Bessent helped to curb (market) fears about stagflationary effects from proposed policy changes.

Footnotes

¹ For example, a significant negative monetary policy shock could be observed in our framework on November 12th, when the Wall Street Journal ran an article ‘If Trump Tries to Fire Powell, Fed Chair Is Ready to Fight It’ and mostly dovish Minneapolis Fed President Neel Kashkari warned about a possible pause in the rate-cutting cycle (see the figure 3b).

² Höynck, Christian, and Luca Rossi. "The drivers of market-based inflation expectations in the euro area and in the US." Economics Letters 232 (2023): 111323.

³ Ricci, M., “The link between oil prices and the US dollar: evidence and economic implications”, Economic Bulletin, Issue 7, ECB, 2024.