So, what do the President-elect Trump’s plans mean for key pieces of legislation, the Fed’s independence, US inflation, long-term interest rates, bond prices and M&A activity?
The Glass-Steagall Act was introduced after the 1930’s Wall Street crash to separate the commercial and investment banking activities to afford greater protection for depositor monies and regulate banks’ investment risk. The act was later repealed by Clinton’s government. The Republicans argued that the Democrats were responsible for creating instability from the excesses of the banks such as Goldman Sachs who they saw as positioned with their party. Trump would like to see this Act brought back to life in as much as to appease his populist voters but it will also mean a flurry of demerger activity from the resultant breakup of the larger banks. On the other hand, the banks could see some easing of restrictions on stress testing of their balance sheets and ability to invest their own money. It would mean pushing through the Finance Choice Act promoted by the party’s House of Representatives’ Financial Services Committee and repealing the Volcker Rule which bans proprietary trading.
The Wall Street crash was followed by the US housing and loans crisis of the 80’s after Reagan’s enactment of the Garn-St Germain Act. The deregulation of the banking industry occurred after the lifting of the gold standard and a period of hyper inflation, around 15%, during Carter’s presidency and destroyed many of the thrift banks. Interest caps were lifted, insurance on deposits was increased, and capital requirement was reduced. The earlier Tax Reform act, spurned the creation of artificial tax shelters, by restricting accelerated property depreciation, allowing passive property losses to be offset against other income whilst property appraisal laws were relaxed and thus encouraging artificial land flipping and ballooning of property debt which lead to the collapse of the Federal Savings and Loan Insurance Corporation (FSLIC).
The Dodd-Frank Act, enacted in 2010, was President Obama’s response to the earlier decade-long global recession and US housing crisis, fuelled by subprime mortgages. The act was promoted by the Democratic Senator Elizabeth Warren who was also the patron of the Glass-Steagall Act. Amongst other things, the Frank-Dodd Act introduced an independent consumer bureau to regulate financial institutions and make transparent the dealing of derivatives and restrict the Feds ability to bail out ailing and irresponsible entities. This was after the insurance and mortgage and banking debacle of 2008 when the US government took an eighty percent stake in AIG providing an $85bn bailout package and also rescued Freddie Mae and Freddie Mack but allowed Lehman brothers to go to the wall. The Republicans are very critical of this extensive legislation arguing that it has spawned enumerable and ineffective government agencies; a smack on the face of liberty and the placing of an unnecessary strangle hold on the financial industries ability to do business.
So, it does seem that it will be a case of out with the new and in with the old. It appears that Trump will get rid of the Consumer Financial Protection Bureau and water down the Dodd-Frank Act hoping to breathe life into the strait-jacketed financial institutions. At the same time, we may see the reincarnation of the Glass Steagle Act and the slacking of the US bank’s balance sheets and this may well lead to a flurry of M&A activity before the next midterm elections.
What lies ahead for the FED? There is the talk from both parties for more political oversight and auditing of the FED. Congress is responsible for implementing fiscal policy in regulating the US economy but until Trump’s victory, the ability to apply meaningful fiscal triggers has been slow and constrained. Therefore, the Fed through its seven governors has had to pilot the US economy through the use of monetary tools such as monetary supply, interest rates, debt issuance and quantitative easing measures. Inflation is below 2pc but rising manly due to increase in shelter and energy costs, the Fed is expected to raise interest rates again next month by 2pc, the last increase in interest rates was in December of last year after a decade of flat lining. Janet Yellen, the Fed’s chair, has warned Trump that political meddling will stoke hyperinflation if the Fed is forced to dance the governments tune. Interest rates will remain relatively low providing the economy does not overheat from misplaced fiscal expansionary plans. The most we can expect is a greater oversight of the Fed by the legislators and the Fed’s continued independence.
There are signs of a dangerous trend; each of the previous financial crises was followed by the respective new governments introducing quick-fix pieces of deregulation only to be followed by institutional control fraud. Are we, therefore, heading for repeat of the same medicine?
Finally, I would like to turn to the question of bond prices and bond vigilantes. The central bank has the role of controlling the money supply and in the US it is the Fed. The Fed does this in several ways; by the issuance of bills on behalf of the US government, Open Market Operations in the buying and selling of second-hand bonds, notes and T-bills, setting minimum reserves for the US banks and proposing the appropriate interbank Federal Fund Rate. However, the ability of the Fed to regulate interest rates has been increasingly tempered by the vigilantes operating in the burgeoning bond market by some estimates close to $100 trillion (see page 18 in https://www.bis.org/publ/qtrpdf/r_qt1403.pdf), about a third of which is in US securities. We saw the influence of the bond investors during Clinton’s reign when he wanted to boost spending and plug the budget deficit with borrowings. The bond investor’s response was to sell off their holdings causing a hike in the yields and thus curtailing Clinton’s spending plans. After the shock of the recent 2016 election results, almost a trillion was wiped off the bond market, equivalent to a 1pc yield increase. We are experiencing a repeat of what happened during Clinton’s time. The vigilantes are preparing to offload their investments in the face of Fed’s anticipated rate increase and Trump’s fiscal spending and tax reductions plans, his curtailment of immigration and cheap imports from China and Mexico. The threat of rising inflation will hurt the bond holders who receive fixed coupon interest and thus bond prices will fall creating trillions of loss in investment and rising yields. The new government may have to reconsider how it intends to plug the public deficit. Frank-ly it is a Dodd-le, right?
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Article written by Haroon Rafique (Principal, Meer & Co Chartered Accountants and Tax Consultants)
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