Kathleen Hays of Central Bank Central was kind enough to ask for my initial response to the election. Here’s the interview (edited for readability) which was recorded the day after Election Day.
https://kathleenhays.substack.com/p/kotok-stocks-rally-on-trump-victory
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Kathleen Hays Presents: Central Bank Central
Kotok: Stocks Rally on Trump Victory with Eye on Tariffs, Tax Cuts, Budget Deficit
November 6, 2024
KATHLEEN HAYS:
Welcome to Central Bank Central. I’m Kathleen Hays.
Well, we knew this would be a big day one way or another. And in fact, now Donald Trump has won a resounding victory. Republicans taking charge in the Senate. Will they take charge in the House as well? It looks like that is still unknown and also possible.
Joining me now is David Kotok, the author and regular producer of the Kotok Report. And David likes to put things in historical perspective, current events in the markets, in the global economy, central banks around the world. And in keeping with that, he is just ready to publish his latest book called The Fed and the Flu. We’ll get to that in the interview as well.
David, let’s just start with one of the most basic questions of all. Donald Trump has won. He has put various measures on the table. Kamala Harris had put various measures on the table as well. Whether other voters were going more because they like what Trump says, what he’s going to do, or they just don’t like what the Democrats wanted to do, led by Kamala Harris, remains to be seen.
But I want to start on one of the most basic things of all. The market reaction, what stands out in how markets are reacting? Are they saying “Yes, thumbs up to Trump”? Are they cautious? And put that in context, too.
DAVID KOTOK:
Well, if you talk about markets and look at the stock market, clearly the stock market liked the outcome of the election. We saw the spike as soon as there was some clarity about the outcome. So stock markets, yes! Why? Harder to know. Is it because they expect tax cuts for corporations? Is it because they expect more fiscal stimulus? Lots of reasons we could speculate about. Credit markets: Treasury notes and bonds sold off; the yield curve steepened. Does that mean we’re going to have more inflation? Does that mean recession is less likely? What does it mean? That’s interpretation. What we do know is market-based prices changed dramatically in treasury yields. And there’s an obscure market for Americans, the credit default swap on the United States. Americans don’t trade credit default swaps. They don’t know what they are. If we ask 99 out of 100 people, they’ll look at us and their eyes will roll.
But the credit default swap market is what foreigners use to insure payments against the United States. And the one-year credit default swap today, this morning, hit an all-time new high of almost 50 basis points.
Now, who uses the credit default swap? Foreign institutions, sovereign wealth funds, foreign insurance companies. They’re the ones who say, “We don’t know if the Congress of the United States is going to have the threat of another debt default. We don’t know if there’s going to be huge deficits. We don’t know how things are going to be paid for. We don’t know the outcome of a tariff war. Will it be selective or will it be a repeat of the Smoot-Hawley tariffs in the 1930s?” We don’t know. So what did we say today in a market-based price? We want higher insurance, and that means the people who supply that insurance can get a higher premium from the people who want to buy it.
So we had all kinds of market reactions, and they were the initial reactions. I would just say one other thing, Kathleen. Tariffs are in the executive power. Donald Trump can apply tariffs like he did or like Biden continued. They don’t need Congress to use tariffs.
And Congress certainly is not going to take back the authority it gave to the executive branch years ago. And no president would give it up without a fight. So tariffs are an open issue that do not require the Congress. Taxes require the Congress. Budgets, deficits, borrowing, the Congress.
And any changes in the policy of the Central Bank of the United States and the appointments and confirmation of governors and the chair require the Senate or the Congress. So that’s ahead of us. And that’s a big unknown.
And the last unknown today is we don’t know what this massive lame duck session is going to look like in the next few weeks.
KATHLEEN HAYS:
Well, let’s break this down one by one. And there’s a lot of things on my list, but let’s go directly to tariffs because from the very beginning, I thought, look, Donald Trump is a guy who likes to bargain, right? He wants to negotiate. My first thought was, oh, is he really just going to throw tariffs on the whole world? Or is he going to go to various countries and use this as a tool to move them in a certain direction? Certainly, he said publicly while he was campaigning that what he wants is to see more direct investment. I want to see more overseas companies putting production facilities in the United States. So is it possible that this is something that has only begun and it’s very hard to, as you say, no one knows, but is it possible that that’s what he’s really aiming for?
DAVID KOTOK:
Well, that’s a great question. And the answer is maybe. Because the fact is we know Trump uses hyperbole and exaggeration in almost everything he says. What does he do? What do you do when Samsung has got $4 billion being invested in making chips in Indiana?
What do you do if Taiwan Semiconductor is doing a chip act expansion in the billions in Arizona? Do you derail them with tariffs? How do you use them? Do you reward South Korea, which is now dealing with a military issue because of North Korea and the Russians? You know, there are so many extraordinary, extraordinary global issues unresolved.
And this campaign and political campaign, which seems like it was a marathon of years, didn’t address them, didn’t discuss them. We’re now going to have to confront them. So campaigns are one thing. Now we’re in the real world. It’s about governance. That’s what it’s about.
KATHLEEN HAYS:
Well, you mentioned that fact that the stock market rallied. Okay. Is the stock market then feeling pretty positive about the kinds of steps that Trump may take and what they’re going to mean for the economy, therefore for corporations’ profitability, their earnings statements, et cetera?
DAVID KOTOK:
Well, I think the stock market is trying to discount. First of all, the stock market has a huge relief rally because uncertainty has been replaced with an outcome. And uncertainty is the enemy of the stock market. The stock market can deal with good news or bad news. It can deal with war. It can deal with peace. It can deal with pandemics. We discuss that in my new book in detail. But what it can’t deal with is uncertainty. 48 hours ago, we had uncertainty. Now we know. Whether some people like it or not or don’t like it is irrelevant now. They can commiserate all they want. The outcome is known.
So we are now dealing with projecting scenarios in the outcome. And Trump has an opportunity. If Trump takes the opportunity of leadership, clarity, and credible proposals that are debatable for sure, but acceptable, he may succeed and 2.0 may not be such a bad outcome. Although everybody was afraid of it, including….
KATHLEEN HAYS:
Well, not everybody actually David, because a lot of people.
DAVID KOTOK:
No, you are correct; some people. Half the people.
KATHLEEN HAYS:
There’s two big, strong trends here. And the Trump trend won this time. And he was supported by all kinds of people. It wasn’t just billionaires or something that voted for Trump. It was all kinds of regular people.
DAVID KOTOK:
Yes, no question about it. You know, that’s our system. I am a defender and believer in our system. We are an experiment that’s over two centuries old. And Lincoln used the words, “Will it endure?” And it has endured an awful lot. You look at all of our history, it has endured a lot. So I want to believe that it’s not over, it will endure, that the balances and the system will prevail. And if it doesn’t, Kathleen, then we no longer are the light on the hill that Ronald Reagan described.
KATHLEEN HAYS:
Mm-hmm. Well, okay. And I think that’s how a lot of people feel. And obviously, like I said earlier, I mean, some people may have just, who voted for Trump, were voting against Harris. They were voting against the policies that Democrats have promoted for the past four years, for example. That seems to be the case, right?
And some may have voted more positively for Trump, right? But we know he’s there now. What do you think then in terms of the economy — there has been concern about the Fed, about the economy weakening. Actually, inflation doing better, the economy weakening, particularly labor market, et cetera. What do you expect from Donald Trump in terms of What’s going to happen with the economy?
DAVID KOTOK:
Well, if we don’t get huge federal borrowing, which is a big issue, fiscal dominance is the new code word. You’ve been interviewing. I watch your podcast. You’ve been interviewing skilled people with long histories, some of them having served in the Fed in the most intense periods. And fiscal dominance is a repeating theme.
If the United States starts to borrow six, seven, eight percent of GDP year after year, what is the Fed going to do? And how can it restore size in a balance sheet to something smaller in such circumstances? And what should the real interest rate be? And by the way, we don’t know. That’s a big debate, too. You’ve had it on your show. The fact is, we don’t know what “r” star is. We know what the concept is. So massive questions about central banking.
KATHLEEN HAYS:
Let’s go back to the fiscal question, because this is a very big one. It was a big one during the election, certainly for people at the Fed, people in the markets, that the budget deficit is large and growing. Both candidates and certainly Donald Trump pointing in the direction of cutting taxes because that will create growth and that will create more tax revenues, and not being worried about the budget deficit because there’s a way we’re going to grow out of it. What do you make of that?
DAVID KOTOK:
Well, the promise of growing out of a deficit has happened in the past. We’ve seen it in the past. It doesn’t seem to completely happen. And so I’m always skeptical of, “We’ll enlarge the deficit now, but we’ll get it all back and balance out tomorrow because we’ll have so much growth.” That’s the old supply side economics argument of yesteryear.
And will we get it this time? Maybe it’s different, but I’m always leery of, “This time is different.” I think there’s a different possibility because Trump’s history is not to be very caring about the size of the deficit. He has always used debt. Debt is part of his financial history. Bankruptcies in his companies in the past. Debt is not something he sees by his own actions as a high standard of calling. But markets provide disciplines. Bond vigilantes provide disciplines. And so if he proposes and the market disposes by raising the borrowing cost to reflect what is proposed, then the Congress is going to say, “Whoa, there’s a cost benefit analysis we have to do.” Congress isn’t going to do it if Maya MacGuineas publishes a study, bless her heart, about how big the deficits will be. That’s the Committee for Responsible Federal Budget. Or if the Wharton School does a debt analysis.
I went to the Wharton School. I know how to read a debt analysis. 99% of Americans will never open the document. So that’s not what’s going to do it. But let the home mortgage interest rate of a new home buyer be up 100 basis points and let the realtors not be able to sell houses because interest rates spiked because of big deficit proposals. And then you get a reaction. So that’s what’s ahead of us. We’re going to find out. It’s going to be a fascinating journey.
KATHLEEN HAYS:
It certainly is. And let’s talk about the Fed here, because when we talk about the fiscal dominance now, that’s more important in many ways now than monetary policy dominance. We move from interest rates to the budget deficit and whether or not Congress steps up. But in terms of the Fed right now, if there’s going to be more stimulative fiscal policy, does that mean the Fed is going to have to be more vigilant in fighting inflation? Right now, it’s all about, “Oh, no, inflations come down a lot, and the labor market, we think we’re getting a soft landing”, et cetera. But don’t they have to be looking ahead, or do they have to be looking ahead to next year? And what’s going on there? Is it wise to be cutting rates now when you might have to be raising them later if some of these fiscal forces play out?
DAVID KOTOK:
Well, the Fed is on the horns of a real dilemma. They may cut a quarter point here or even another couple of quarter points. But the fact is they have to confront the size of the balance sheet and how to shrink it or to stop shrinking it. And at the same time, to keep a real interest rate positive. So in order to keep a real interest rate a positive number, they have to take an estimate of what the inflation rate is and add a couple of points to it. So if they think the inflation rate is two and half or three, they have to keep the Fed funds rate at five. And that’s what the market is saying is coming. Because otherwise.. Otherwise, the credibility of the dollar worldwide is threatened if the real interest rate is not sustained as a positive number. My book looks at that history of central banks and monetary policy for 2,500 years of disruption.
KATHLEEN HAYS:
Well, let’s take a look at that. Because a couple of things I was thinking about, one of the reasons that we have this fiscal condition is what happened during the pandemic. And at the beginning, you could say, “Yeah, you had to throw money in, you had to throw money in”, but the government kept throwing money in. That’s one of the reasons our deficit has gotten to be such a big percent of GDP.
So your book, The Fed and the Flu, going to be published shortly after the first of the year, you spent all during the pandemic, at least, working on this book. So if you take a lesson from that, is there something you can take from The Fed and the Flu and weave it into it? For example, if you could say, “Hey, Donald Trump, President Trump, I’d like to sit down with you and share what I learned from this”, what would that be?
DAVID KOTOK:
Well, the book has an entire section on the Federal Reserve with three pandemics: the Spanish flu, the Asian flu (both of those the Fed essentially ignored them), and COVID, where the Fed had an active policy. We’ve dissected the entire policy. Every item in it is listed.
At the same time, the book looks at historical references. The Ancient Greeks had a pandemic, epidemic in Athens. They had a war. Afterwards, they restored the buying power and credibility of their currency and did so. and the drachma remained the reserve currency for another 200 years in the Mediterranean. The Romans had three pandemics. Each time they debased the currency, never restored it. They had high inflation, wage shocks, monetary chaos. So we looked at antiquity.
I have three wonderful co-authors. Without them, this book wouldn’t be possible. It took us four years. And we looked at everything from the plague in Athens to COVID. And what we found is monetary policy, dealing with fiscal policy, has impacts on inflation, wages, shocks, asset prices, every single time. They are all recited in the book.
What is going to happen now? We have disruption. We have political change. We have war threat in parts of the world. And we have monetary policy that is going to have to confront massive forces. History, for those policymakers who will look at it, can guide. Investors can be guided. But (apply) the words of George Santayana, the famous poet, “Those who ignore their history are condemned to repeat it.” That’s the theme of the book. That’s the theme that has to apply to the Federal Reserve today. They have an enormous challenge ahead.
My view: Maintain the real interest rate. Don’t take it to zero. Let it stay at two. Strong monetary policy can handle fiscal dominance. And don’t shrink the balance sheet anymore. Why do it? It’ll only have to go up in the future. Ben Bernanke said that many times. That would be my view for whatever it’s worth as an advisor to whoever wants to listen.
KATHLEEN HAYS:
Well, you’ve certainly woven together a whole thread of, I think, very important arguments and things that we do hope the next administration will be looking at very closely. And you touched on something, which is one of the things I want to ask you about, because I think markets are watching this very closely for a number of reasons. And that’s U.S. posture, support in the Middle East for Israel, Ukraine. Is that going to change? And I say markets – well, certainly there’s a lot of uncertainty. There’s a lot of uncertainty there. Investments, obviously, when you look at defense spending, for example, which there may be a push to boost that more now. It would have been from Congress, and it would have happened potentially with either victor here, President Trump or Vice President Harris. But under Trump, then, how do you expect that to be handled?
DAVID KOTOK:
I would like to see full funding of the United States defense budget. We haven’t had it. The defense budget is the one thing up until this last two years in the Congress was off limits. The Congress — Democrat, Republican, either chamber — when it came to the defense of the United States, it was funded fully. It hasn’t been funded fully. And we have a world which looks increasingly threatening to me and many observers. I don’t see anybody running around saying, “Kumbaya, peace breaks out, let’s all have love and be celebrating.” The world is dangerous. That takes defense funding. And that has not happened. Will it happen now that the election is over?
I hope so. Because we have to be protective of ourselves. No one’s going to do that for us.
KATHLEEN HAYS:
So, alright. So you think there, and just follow my follow, I guess. So do you think that President Trump, what do we know about what he has said, what he has done that makes us think that under President Trump, that long-awaited by a lot of people, I know a lot of people, oh, why do we want to do that? But so many experts say what you’re saying. Real defense spending has actually fallen, right?
DAVID KOTOK:
Yes.
KATHLEEN HAYS:
And this is not the time to do that. So what do you think Trump, how do you think he’ll handle that? J.D. Vance has been very reluctant, very skeptical of funding Ukraine more and as a way to push back on Russia. What do you think Trump’s going to lead us toward?
DAVID KOTOK:
Well, this is the big unknown in the defense sector. It’s the big unknown in geopolitics. We have 10,000 North Korean soldiers integrated in Russian units, within miles of the Ukrainian border, but within the Russian boundaries. But remember, they are also close to the Polish border. There are other borders. What do we do as the United States? What is our view? Now, Trump has said he wants the Europeans to pay more. Well, OK, I kind of agree with that. They’ve had a free ride or an easy ride. But pay more doesn’t mean abandon supply of war material and the modernization of it. That has to happen for the defense of the United States, not (just) for the defense of other countries in Europe.
KATHLEEN HAYS:
So energy policy – What do you see there? I think I saw, in fact, you know, it was funny because I didn’t stay up super late. And then I woke up about 3 o’clock in the morning. I had my phone by my bed. I opened it and I saw that, from one of the European financial shows, that actually the clean energy stocks were falling like crazy. Is that the assumption markets are making?
DAVID KOTOK:
Well, we’ve heard, “Drill baby, drill.” And it’s not a Taylor Swift rock song. And what do we know? We’re at maximum, highest oil production ever. And it’s probably going to go up. And oil and gas, it’s going to go up. LNG, probably more easily exported. That’s a Trump policy that’s pretty clear. So what will that mean?
The geopolitical argument would mean that hurts Russia because it takes away revenue from who? It would! The domestic activity would say more growth in the energy sector. The climate folks would say, “Wait a minute, more fossil fuel. The planet’s getting hotter.” All of the above are true.
How do we balance all that out? That remains to be seen. That’s the job of governance, not campaigning.
KATHLEEN HAYS:
Right. So since we’re on this, is there any investment right here? Trump isn’t even in office yet. That doesn’t come until January. But that you would say, “Ah, I guess I would think of that as an opportunity now, which I might not have thought before he got elected or if Kamala Harris was elected.” But is there anything that changes in your mind right now in terms of, you know. Put on your chief investment officer hat.
DAVID KOTOK:
No, because my view has been that you don’t bet all your money in any single place. And if anything, we’ve learned from the recent past that a diversified portfolio gets some of the good stuff and dampens some of the bad stuff. And that’s what diversification of risk is about. So I’m still a believer that there will be a tax code. It won’t be eliminated. And when it does, if you’re a high bracket taxpayer, a tax-free municipal bond has a place in a portfolio. Stocks have a place in a portfolio. You could talk about other sectors, private equity, real estate commodities. That depends on the size and diversification of the portfolio. I think they have to be considered. And cash with a real interest rate that is a positive number is a buffer. So that’s my view. But I don’t bet everything in one swoop, in one place, ever.
KATHLEEN HAYS:
So as you wrap this up, I’m just thinking, is there anything else that we want to touch on here? We’ve covered a lot of ground. Thank you very much. I appreciate you taking the time. Is there any other thought, any other aspect of this, again, historic day, historic transition? Republicans look like they’re very much now taking over the power that the Democrats had for a while, right? That level of it. In a time like this, anything else, any other thoughts you want to share, David?
DAVID KOTOK:
The enduring quality of American institutions has been tested over and over again in the past. And they seem to have a rough go but survive. And the enduring capacity of the Central Bank of the United States and our banking system, something that I’ve watched you, Kathleen, deal with your entire professional career, is the finest banking system and central bank clearing system in the world. I would remind people that on 9-11, when the collapse of the financial center in New York occurred in an act of war, what happened with the central bank functions of the United States?
The Atlanta Fed stepped in immediately to replace the New York Fed and cleared. No payroll got missed in California the next day. No real estate settlement in Texas failed because a wire transfer didn’t happen. Nobody says, “Wait a minute, the Central Bank of the United States went through its central clearing under a pile of rubble in New York, and nobody missed a payment.” So we have enduring institutional strength for 110 years in the Federal Reserve, and we love to bash it and criticize it, and it can’t defend itself, but it knows what to do and it doesn’t do a bad job.
My book will list hundreds of examples of good things and things to be critical about. So I’m confident in the American banking system and the Federal Reserve. I don’t think Bitcoin is going to replace the Fed’s balance sheet. That’s nice conversation. It ain’t going to happen in my opinion.
KATHLEEN HAYS:
Alright, David Kotok. Well, thank you so much. And of course, everybody can now look forward to seeing you on Central Bank Central just after the, well, soon, whenever that book is ready to be talked about in depth. Look forward to having you back, David Kotok.
Once again, The Fed and the Flu on the verge of official publication. I can hardly wait. So David, thanks again.
DAVID KOTOK:
Thank you, Kathleen. Nice to be with you.
KATHLEEN HAYS:
As always, I’m Kathleen Hays, and this is Central Bank Central.
