Last week we witnessed one of the most spectacular U-turns in recent policymaking history, with the Art-of-The-Dealmaker-in-Chief Donald Trump backing down from the bombastic announcements on tariffs he made on Liberation Day, on April 2nd. President Trump announced a 90-day moratorium on the application of tariffs for those countries that did not retaliate, while increasing tariffs on China to 145%. He made an exemption for smartphones and other consumer electronics from these so-called “reciprocal tariffs.”
What convinced him to carry out such a spectacular change of direction? Behind-the-scenes reconstructions abound, but the key is that Trump had his first true reality check since the beginning of his second term in office, something that clearly his closest advisors and collaborators are unable to provide him with on a daily basis.
Trump and his administration, which live in a sort of “cult of personality” (as evidenced by the mandate to wear a pin shaped as a golden bust of the boss), believe that they can bully everybody and everything (countries, institutions, rules, etc..) because Trump is at the helm of the strongest country that has ever existed, the only true worthy descendent of the Roman empire, which justifies the so-called “American exceptionalism.”
But last week, Trump was reminded that something bigger than him and his administration exists, which can dictate the rules even to the most powerful country on earth: the market. Until a few years ago, politicians around the globe thought that this was true only for the weaker countries, such as emerging markets, or weak developed economies such as Italy, which live day in and day out with the fear of market discipline and bond vigilantes – the “dictatorship of the spread”, they call it.
But in 2022, the UK learnt that this was true also for the richest and most advanced economies such as the British one. The prime minister Liz Truss presented a “mini budget” comprised of unfunded tax cuts, which was supposed to realise the post-Brexit pipe dream of transforming the economy into a sort of “Singapore on Thames.” The market instead thought that this mini budget would have soon led to a debt crisis. UK gilts sold off while also the British pound lost ground.
The speed of these market movements caused the liability-driven investments (LDIs) by pension funds to become unsustainable. Within hours, the Bank of England had to step in with an emergency facility to purchase gilts and restore calm in the market. The BOE governor, Andrew Bailey, said that the facility was temporary and would not be renewed: politicians needed to back down from their unfounded promises, or else the system would have collapse. Liz Truss had little choice but to resign, and make room for Rishi Sunak, the former Chancellor, a much safer pairs of hands to manage the economy. Actually, in a recent interview Truss admitted that she mulled the idea of sacking Bailey over that weekend. Fortunately, she decided otherwise.
In the US, the situation was similar: the raft of fire-sales triggered by Trump’s announcement on April 2nd had led to the destabilisation of the delicate arbitrage mechanism between cash bonds and the futures on Treasuries (the so-called “basis trade”). Similar to the UK episode, only two options became possible: the Fed stepping in to purchase US Treasuries and the USD (or equivalently, cutting rates with an emergency inter-meeting move), or Trump blinking and backing down.
Fed Chair Powell did well in resisting the pressure to cut rates coming from the White House. At the time in which the Fed has remained the only credible economic institution in the US, with the White House and the Department of Treasury perceived to be the cause of the market turmoil, if Powell had ceded to Trump’s pressures he would have served the country very poorly. He would even have been serving Trump poorly by doing so, as Trump would then have had to deal with a systemic crisis of epic proportions.
What’s the difference with the UK case? In the UK, as was the case of Italy in November 2011, when Berlusconi was forced to resign after bringing Italy to the brink of default, the mechanisms existed to force the Prime Minister to resign. In the US, such a mechanism does not exist, which explains why on Friday 11 April markets sold off again. The authors of the disaster are still at the helm of the ship, and the war continues.
