Expectations for a Messy Stretch
This week, HAI would like to join millions of others in welcoming Donald J. Trump back to the White House. He will otherwise have a chilly reception—the returning President is walking into a mess. The Trump-2 administration is now facing a toxic emerging market-like combination of debt and inflation. Consequently, the Federal Reserve and its monetary policy toolkit is largely trapped. The Fed can hold rates high or even raise rates further to help fight inflation, but only at the cost of triggering an interest expense-fueled debt spiral. Or the Fed can cut interest rates on the short end of the curve and issue short-term T-bills to finance the government at a lower interest expense—but only at the cost of likely supercharging inflation. In other words, it now appears that the Fed is down to lose/lose policy optionality as Trump begins his second term.
This Thursday, however, President Trump strongly indicated exactly which way he intends for the Fed to lose. In a video conference with the World Economic Forum (WEF) in Davos, Switzerland, the President made it clear that he wants the Federal Reserve to significantly slash interest rates. He later suggested that he understands monetary policy far better than those charged with setting it.
In his virtual address to the WEF crowd in Davos, Trump said, “With oil prices going down, I’ll demand that interest rates drop immediately, and likewise they should be dropping all over the world.”
Then, later Thursday, in comments made to reporters in the Oval Office (in an apparent reference to the Fed and Chairman Powell), Trump said, “I think I know interest rates much better than they do, and I think I know it certainly much better than the one who’s primarily in charge of making that decision.”
So, it didn’t take President Trump long this week to re-kindle a fight over interest rate policy with the Federal Reserve and chair Powell that originally began in Trump’s first term. Based on comments from Trump and his Treasury Secretary nominee Scott Bessent, it appears the administration’s game plan is to reduce the budget deficit to 3% of GDP by 2028, boost growth to 3% through deregulation and pro-growth policies, and to “drill, baby, drill” an increase in U.S. energy production by three million barrels of oil (or oil equivalents) per day.
In short, the key to Trump’s initial fix for America appears to be lower energy prices. The idea is that the boost in oil supply will reduce oil prices. With oil prices lower, inflation will ease back towards the 2% target. With inflation in check, the Fed can then cut interest rates sufficiently to boost growth and reduce the deficit through a combination of higher tax receipts and a lower interest expense.
It’s not a bad idea, but it’s also not a plan that will be nearly as simple or straightforward as the administration might advertise. OPEC+ is currently sitting on plenty of spare oil production for a reason—to keep oil prices elevated and sufficiently profitable. There is no obvious reason why OPEC+ wouldn’t continue to slow production to offset any material increase in U.S. oil production. Furthermore, and importantly, U.S. shale is facing the challenge of increasing break-even prices and rapidly increasing shale decline rates. The Federal government may decrease regulatory hurdles and increase the territory available to oil producers, but that does not necessarily mean that the oil industry will act on this with a material increase in production. Profitability, in the end, is key. And even if the administration succeeds in manifesting the increased production it seeks, the added supply may well weigh on prices, and those lower prices could easily prove counter-productive by quickly slipping below the increasing shale break-even thresholds. Ultimately, the dynamics of increasing break-even prices and rapidly increasing shale decline rates are likely to keep oil prices stubbornly resilient.
In addition, it’s also important to understand the federal leasing process, as new federal land leases are the most important variable when it comes to analyzing the impact that any U.S. administration can have on oil production. A typical federal lease for oil and gas production works through the Department of the Interior (DOI) via the Bureau of Land Management (BLM) (onshore), and the Bureau of Ocean Energy Management (BOEM) (offshore). These agencies conduct lease sales of eligible federal land on a quarterly basis. Once a producer successfully bids for a lease, they will proceed to perform a geological assessment of the land to see its viability for production. But consider that the American Petroleum Institute (API), the trade association for the natural gas and oil industry, estimates that this assessment can take 3-4 years for onshore leases and 7-8 years for offshore leases, due to greater engineering and logistical challenges.
So, while there is certainly scope for significant regulatory changes that could lower barriers and costs, make it easier to obtain permits to drill on federal land, and potentially reduce the break-even prices of oil producers, this does not guarantee that we will see a significant increase in U.S. oil production over the next four years. Any significant boost in oil production in the United States stemming from deregulation policies under President Trump will most likely be seen only after he leaves office, and that makes the goal of increasing oil production by three million barrels a day and a concurrent near-term drop in oil prices extremely hard to achieve before his term ends in 2028.
In HAI’s view, Trump’s best bet in terms of materially increasing production and reducing oil prices at the same time on a shorter time horizon would involve some sort of potent tax incentives or outright subsidies. That’s certainly not out of the question by any means, but it would still take time, and there’s also no guarantee that OPEC+ wouldn’t retaliate.
Furthermore, in HAI’s view, Trump’s agenda is facing an even more profound mega-complicator. Testifying before the U.S. Congress in 1960, economist Robert Triffin famously exposed a fundamental flaw in the international monetary system. In what’s since become known as “Triffin’s dilemma,” Triffin explained that in order to maintain the global reserve currency, the issuing country necessarily must be able and willing to supply the world with sufficient quantities of its currency via structural trade deficits in one form or another.
As Triffin described, the hegemonic benefits of being the reserve currency nation outweigh the costs at first. But the dilemma is that while the benefits of being reserve currency issuer stay relatively static, the costs compound over time. Eventually, the costs outweigh the benefits and the system becomes unsustainable.
Put simply, there is a natural economic entropy to global reserve currency status because inherent flaws in the system continue to compound, tension builds, and eventually the system hits a breaking point.
In HAI’s view, the post-1971 dollar-based global monetary system—with the dollar as reserve currency and Treasurys as primary reserve asset—is proving Triffin’s point. We’re now decades into this petrodollar system, and the negative consequences of Triffin’s dilemma have arrived.
The structural global demand for dollars and Treasurys has ensured a perpetually overvalued dollar and a mechanical global bid for U.S. Treasurys. Again, at first this allows the government to borrow and spend far beyond what fundamentals would allow for a non-reserve currency issuer. Despite fiscal profligacy and monetary recklessness, the dollar remains strong, and foreigners continue to bid for our debt. Again—convenient, at first. But over time the net result is a country encumbered by a rapidly growing $36.2 trillion mountain of debt and $2 trillion in annual deficits as far as the eye can see. As a consequence (or cost, in Triffin terms), we now have an inflationary debt-spiral and a helplessly trapped Fed relegated to the sidelines.
What’s worse, the artificially strong dollar (as a result of the insatiable international demand for dollars to pay for oil and commodities under the petrodollar system) means that, over time, U.S. domestic manufacturing has become entirely uncompetitive. Over decades, U.S. manufacturing has become hollowed out and atrophied. Yes, Americans benefit from the ability to buy cheap goods from cheaper overseas manufacturing hubs, but the benefit has cost too many U.S. middle class manufacturing jobs, and it’s also become a threat to U.S. national security.
Two weeks ago, the NATO Secretary General spoke volumes when he said, “when you look at what Russia is producing now in three months, it’s what all of NATO is producing from Los Angeles up to Ankara in a full year.” In other words, after decades of the petrodollar system and the impact of late-stage Triffin’s dilemma-like dynamics, the U.S. manufacturing miracle of old can no longer keep pace with even the productive capacity of a war-torn and heavily sanctioned Russia when it comes to the war in Ukraine.
And it’s not just military supplies that are at issue. Last week in his Secretary of State confirmation hearings, Marco Rubio put it plainly. Rubio said, “If we stay on the road we’re on right now, in less than 10 years virtually everything that matters to us in life will depend on whether China allows us to have it or not.” That’s nothing short of a downright chilling assessment.
So, this week Trump walked into an inflationary debt-spiral dynamic with a trapped and sidelined Fed. He must deal with late-stage Triffin’s dilemma-like dynamics that are coming to a head. It’s all a tall task. So far, beyond the potential drill, baby, drill solution for inflation, it seems Trump is counting on tariffs to help rebuild America’s manufacturing might and, by extension, to shrink America’s trade deficit. But as Triffin pointed out, you can’t materially shrink the trade deficit of a reserve currency issuer without undermining the functioning of that existing global monetary system.
The good news is that a problem understood is half solved, and Trump, Rubio, Bessent, et al. seem to understand America’s problems in all their gravity. The bad news is that, as HAI stated last week, even in the best of circumstances, the road from here to revived national health will likely be neither smooth nor easy. Big fixes are now needed for Trump to “Make America Great Again,” and more often than not, big fixes are messy. Amid expectations for a messy stretch, HAI expects the attributes of gold to shine bright, and continues to view gold as central to any asset allocation strategy for the coming Trump years.
Weekly performance: The S&P 500 was up 1.74%. Gold was up 1.72%, and silver was nearly flat, down 0.05%. Platinum was up 1.01%, and palladium was up 5.51%. The HUI gold miners index was up 3.10%. The IFRA iShares US Infrastructure ETF was nearly flat, up 0.02%. Energy commodities were volatile and down on the week. WTI crude oil was off 2.24%, while natural gas was down 9.92%. The CRB Commodity Index was down 0.40%. Copper was nearly flat, up 0.08%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 0.71%. The Vanguard Utilities ETF was up 0.65%. The dollar index was off 1.79% to close the week at 107.25. The yield on the 10-yr U.S. Treasury was flat, closing unchanged at 4.63%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
