Why Trump fever is boosting interest rates

Throughout November, interest rates have been rising around the world. This means that U.S. debt has grown slightly more expensive. Why? One word: Trump.

No one knows what the Trump administration is actually going to do, but the financial markets have clearly decided that they do. They've concluded that he's going to massively cut taxes and increase spending. Indeed he has promised both big tax cuts and a big infrastructure spending plan, although he has promised a lot of other things too. This would deliver a real boost to the economy. But it remains to be seen whether that's what Trump intends to do, or whether he can get it done. On the other hand, the markets seem to have discounted Trump's talk of trade wars, which would hammer the economy, let alone the prospect that through a mix of incompetence and aggressiveness he could spark a massive global conflagration.

They have clearly decided that he's going to cut taxes, boost spending, maybe deregulate, and not do anything economically destructive. That means they anticipate rising interest rates.

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How does that work? And what do interest rates mean, anyway?

In financial markets, the rate of return generally correlates with risk. This means that riskier assets return more money in exchange for greater risk, and less risky assets return less (but they're safer). And when the economy is bad, investors on the whole become risk averse. It makes sense: When the economy is bad, riskier projects become even more likely to fail, and so investors get cold feet.

This means that interest rates across the economy go down. Investors want to hold fewer risky assets like stocks, and more safe assets like government bonds. Because there's more demand for government bonds, the government can sell bonds at a lower interest rate. In other words, people are so desperate for safe assets that they're willing to get a lower rate of return in exchange for the safety of government bonds.

Now that the markets are predicting — again, rightly or wrongly — that Trump will be good for the economy, that process is reversing. Stocks are up, which means investors want more risky assets, and so interest rates on government bonds have gone up. Once the interest rate on the safest asset class — government bonds — goes up, the interest rates on other asset classes go up as well. Nobody would buy a corporate bond that returns the same as a government bond, but is less safe. So the rates on corporate bonds increase.

Now, some people are already saying that "the era of low interest rates" that began with the financial crisis in 2008 is over. Let's not kid ourselves. On a historical basis, interest rates are still very low.

The macroeconomic fundamentals of the world's major economies have remained the same. The West's advanced economies still suffer from depressed demographics, stagnant productivity, depressed demand, and conservative central banks. All of these things point to sluggish economic growth, and that means that rates are still likely to stay historically low.

Right now, marginally higher rates mean marginally more expensive mortgages and consumer loans, and that's not great for the economy. For interest rates to truly go up, there would have to be a major boost to productivity or another driver of economic activity, which would be good news indeed. But we're not there yet.