Trade Deals and Central Banks Dilemmas

Risk assets mostly rose in July, with equity markets across all major regions advancing while government bonds continued to lag. President Trump’s expansive ‘Big Beautiful Bill’ (BBB) was signed into law on 4th July and the increased government spending plans helped equity market sentiment, as did progress announced on trade deals and encouraging corporate earnings. Government bond prices fell modestly, as yields rose in response to higher inflation expectations, an unwanted development for central banks.

The BBB is essentially a package promising lower taxes and higher spending in the US and its effect on markets has been to push recession fears further into the background and to turn the spotlight back to inflation which increased to 2.7% in June, the highest level since February. On a long-term chart this is merely a blip but, with nervousness around the impact of both tariffs and the BBB, future inflation expectations have increased, resulting in government bond yields and the US dollar pushing higher. There are also growing concerns regarding the sustainability of the US fiscal position, as the Trump administration will increase borrowing through implementation of the BBB, in stark contrast to the brief, deficit-reduction efforts previously championed by Elon Musk. With inflation edging higher again and stocks reaching a new all-time high, the case for cutting interest rates is hard to make but this has not stopped Trump from loudly vocalising his desire for Chair Powell to “cut rates now”, therefore presenting the Federal Reserve with an awkward dilemma.

The fundamental problem is that higher rates make the interest payments on US Government debt far more expensive. Indeed, the chart below shows that government interest payments have increased markedly since the Federal Reserve started hiking rates in 2022 and explains why there is mounting pressure to take steps, such as interest rate cuts, to limit borrowing costs. On a more positive note, high government interest payments also result from elevated levels of spending which supports jobs, consumer finances and corporate earnings and, so far, results for the second quarter have pointed to resilience.

There is also a growing dilemma for the Bank of England. UK inflation increased to 3.6% in June, way above the 2% target. The rise from a 1.7% low last September is due to many factors – regulated energy prices and air fares have increased, while labour costs have been bolstered by higher minimum wages and employer’s national insurance. Price inflation for goods, which are internationally focused, has also started to rise, perhaps reflecting a tariff impact as companies try to protect margins by spreading costs across the globe. At the same time, unemployment has risen from a low of 4.0% last August to 4.7%. This simultaneous rise in inflation and unemployment is unwelcome – if interest rates are lowered to provide support to businesses and jobs, this could add more inflation pressure. Even so, Bank of England Governor Bailey continues to express a bias towards further interest rate cuts this year – good news for borrowers. UK stocks took their cue from positive developments on trade, such as a deal with India and a preferential US trade deal, to hit record highs in July.

Positive trade talks between the US and Japan, Europe and China also helped support these markets last month. Previously, Trump had threatened 25% and 30% tariffs on goods imported from Japan and Europe respectively; both have been lowered to 15%. This number is still considerably higher than the market expected before April’s ‘Liberation Day’ announcements and a level which has the potential to cause economic disruption both for the US and its “allies”. However, these deals at least provide some level of clarity to corporates and investors following what has been an extremely turbulent period and we view this favourably. There are still bridges to cross though – talks between the US and China are still ongoing, although have been described by US negotiators as “constructive”, but, at the end of the month, Trump announced fresh tariffs on more than 90 countries (including Canada, India and Taiwan) as negotiations had not been resolved before the 1st August deadline.

Bottom Line

Despite inflation creeping higher, policymakers remain more biased towards rate cuts, helping consumers and businesses, than to putting on an economic brake by raising rates. Trade deals help to provide clarity for businesses, encouraging investment, but much uncertainty remains over ongoing negotiations across many regions. Policymaker rhetoric and actions will continue to be closely watched, with lots of potential for bumps in the road, particularly given strong gains in stocks over recent months. Overall, though, this is an environment that we expect to offer further support to asset prices over the coming quarters while bonds may be more challenged against the backdrop of government excess and inflation.

Noteworthy Points in July

Sleepy no more: FTSE 100 hits 9,000

On 15 July, the FTSE 100, the benchmark index representing the UK’s largest listed companies, achieved a historic milestone by surpassing the 9,000-point level for the first time in its 40-plus year history. Remarkably, the index added 1,000 points to gain its first ‘9-handle’ in less than 18 months, a sharp acceleration compared to the almost eight years it took to rise from 7,000 to 8,000. This surge in the once ‘sleepy’ FTSE 100 has been driven by renewed investor optimism in UK PLC, underpinned by strong corporate earnings from heavyweights such as Rolls-Royce and Lloyds Bank, as well as growing confidence around anticipated Bank of England rate cuts and progress on UK–US and UK–India trade agreements.

Trump and Powell, what happens if Trump fires the Chair of the Federal Reserve?

It is no secret that President Trump has a level of disdain for Jerome Powell, the Chairman of the Federal Reserve, for his alleged inaction in cutting interest rates which would help to reduce the interest payments on US government debt. This move would be questionable against the backdrop of US economic strength and stubborn inflation. The tension came to a head in July when a leaked White House memo alleged that Trump was about to dismiss Powell and install a Chair that would cut rates, an unprecedented move that would have undermined the institution’s credibility. The market reaction saw the yield on short-dated US Sovereign Bonds fall sharply as the market anticipated a quicker pace of rate cuts, however longer-dated bond yields rose aggressively due to greater inflation concerns and reduced trust in long-term US credibility. Correspondingly, US equity markets and the US Dollar sold off. The only asset to rise was gold, a store of value during crises. Characteristic of the recently erratic US policy, this leak was quickly quashed by the White House and the market moves reversed within an hour. The Federal Reserve elected to keep rates on hold in July, causing further disdain from Trump.