Tim Graf (TG): This is Street Signals, a weekly conversation about markets and macro brought to you by State Street Global Markets. I'm your host Tim Graf, European Head of Macro Strategy.

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And with that, here's what's on our minds this week.

TG: Since taking office a month ago, it would be reasonable to say that Donald Trump and his administration have been engaged in what his former advisor Steve Bannon called ‘flooding the zone’, making policy announcement after policy announcement, some more serious than others, with the effect of disorienting the media. It makes it difficult to focus on what might see the light of day as realistic policies, think here, tariffs, sharp cuts to the size of government, and negotiations to end the Ukraine War, and what are more likely crazy pie-in-the-sky ideas that are promoted to spark a visceral response.

Markets have perhaps had more difficulty adjusting than previously anticipated. Most of the consensus Trump trades worked pretty well before the inauguration, but have not really kicked on ever since. In fact, since the start of the year, US rates are pretty flat, the dollar is actually weaker, and US stocks are higher, but are underperforming markets elsewhere. Not really what we expected.

So to assess where we are and where we're going, I'm pleased to bring Peter Vincent from our trading desk back to talk about what it all means for the coming months. Pete runs trading in Europe for State Street Global Markets, and he always brings a keen eye for where risk reward looks most appealing in interest rate and FX markets.

TG: Morning. How are you?

Peter Vincent (PV): I'm good. I've been busy. I've got to get my head in the game.

TG: You got to switch the mode from trading mode, which is clearly much, much easier than doing the podcast over to podcast mode.

PV: It is, to be honest.

TG: Well, cool, Pete. I wanted to talk to you about the second Trump administration on this podcast. And markets approached his second term with the consensus view that rates, stocks, particularly US stocks and the dollar would all be higher. And this hasn't really played out. US yields since Inauguration Day are pretty flat. Yields elsewhere actually are rising, particularly Europe, but not in the US.

The dollar is actually, I was surprised to see this morning, one of the worst performing currencies year to date. And US stocks have underperformed a lot of other markets, and the Eurozone in particular, by about 9 percent.

Why do you think this is?

PV: So just to qualify that, when you say year to date, the dollar did actually finish on pretty much on its highs, or started the year on its highs in January. So it might be a point of reference there.

But yes, broadly, since the inauguration, you could say it's probably gone sideways. I think there's a couple of reasons for that. Obviously, the election, huge event risk, everyone's fearful of Trump and what he may do. And what you find around, whether it's large economic numbers like payrolls or big event risk like this, you often find the market puts in tops and bottoms, particularly if you've got a situation where the market is very fearful of one side of the trade.

So if you think coming into the election, Trump's 50-50, he wins the election, the dollar rallies on that whole outcome, and then people are looking at what he might do. And the market narrative was very much how big, how large are these tariffs going to be? And also, what's he going to do to immigration in terms of deportations?

So as a rough rule of thumb, I was using 10 percent tariffs as potentially adding one percent to CPI, and a million people deported would potentially also add one percent to CPI. So it's not difficult to realize why people are really worried about the top side for yields depending on these policies. So you have this whole fear factor.

I think the whole market has been waiting, was waiting to the inauguration, and then hoping to get an answer to some of these questions. And really, we haven't had many answers at all.

But what we've had is, you know, tariffs put on in a very strong way on Canada and Mexico and then postponed in the situation with Colombia. You know, I think it was a six or eight hour imposition of tariffs. So the market's kind of gone, okay, this is a bargaining tool. It's not going to be as bad as it potentially could be. And we haven't really had any definitive answers to those questions as yet.

We know tariffs are going on, but I don't think it's any more than anyone probably expected. So lo and behold, we've gone sideways until we find out the answer to those questions.

TG: Thinking about the tariff question more specifically, there's been a lot of interpretation that there is already policy fatigue. As you mentioned, there's the back and forth that was with Columbia, and you had the Canada and Mexico announcements that were backpedaled. Again, within hours, days.

Is the market response and the fact that some of the follow through we might have expected in rates or the dollar, is it fair to say it's down to fatigue, or is it a belief that things just aren't as bad, or that it is just purely a transactional game here?

PV: I think it's just the market pricing in probabilities, Tim, to be honest. So we have the announcement and USDCAD and USDMXN explode, it gets rolled back and they've come off because it's seen as a bargaining chip. And then you have to put that in the context, if we're using those two as an example of how far they've moved.

You know, USDCAD has already gone up 7.5 percent since the FOMC cut rates by 50 basis points. And if you look at MXN, and some of this rise was political news in Mexico, but the Mexican peso is already 25 percent weaker. So the market has already braced for a certain amount of bad news. It's just a case of how bad it's going to be.

There may be a bit of fatigue from traders trying to trade these headlines, but the market will continue to trade the probability. It's totally agnostic to anything else. So I think all that's happened is our worst fears haven't been realized, and it looks like it's a bargaining tool for now. But until we get the answer, I think Mexico and Canada might struggle to strengthen a huge amount from here until we actually know what the outcome is on the tariff front.

TG: I don't want to belabor the point, but there is another lens through which, particularly I look through the world, is in volatility markets. My thesis, which I think is, well, it's certainly been wrong so far, but my thesis was that we needed to adjust risk premia higher to account for the back and forth of negotiations on trade, as well as all these other topics that you've mentioned that we're going to talk about later as well.

As context, we have these MediaStats indicators from our partners at MKT, and they look at the narrative of the trade war. The coverage level of that is actually now, I updated this yesterday, it is actually higher than at any point during Trump's first administration, which I suppose makes sense given all of this headline fatigue we're talking about. Anyway, the coverage is higher.

At the time in his first term, implied volatility pricing, you can proxy it as looking at EM versus DM vol, or just the level of the VIX or the level of the move index was much higher than now. And yet the actual incidence of trade war coverage is way higher now than it was then.

Why do you think there hasn’t been a response in volatility markets to this back and forth?

PV: Because I don't think the market believes there's going to be a really nasty trade war. The one point where the market feared that was when the 25 percent tariffs went on. The response to that when Canada said they would respond over the weekend, and it looked like we were going into a really new phase. So it wasn't just the US putting on tariffs and we move on from there. It was like, this could get quite nasty. The market reaction then was pretty swift. And it happened when the market was closed and the dollar gapped up on Sunday night in the States, Monday morning in Asia.

But then we were already unwinding it as that day we had the postponements. And I think that price action, to me, says the market doesn't believe this is a very nasty trade war. This is just negotiation.

And yes, there will be some level of tariffs because I think it's a key part of the administration's plans. But the market currently views it as being like a speed bump. And we should get over that. And then we can kind of return to the new normal, not that we're going to get this thrown around all the time, getting worse and better. So I think that's the way I'd explain that for now.

TG: And does the notion of reciprocal tariffs, which were announced last week, does that change anything for you? Does it make it any worse or raise the probabilities, in the way you've put it, raise the probabilities of a nastier outcome? Or is it just part and parcel of the same thing?

PV: I see this as part and parcel of the same thing at the moment. You could argue that if it's reciprocal tariffs, that's quite justified. You're just trying to level the playing field. The trouble I've got is the fact we're even talking about this, shows that the market over-recesses about every statement. And I'm just not sure we should.

I tend to try and take a step back, look at the broad backdrop, and then compare that to what's priced in. So at the moment, there's a certain amount of bad news. It could easily be a lot better than 25 percent for Mexico and Canada. And those currencies longer term could strengthen quite a bit. But they're not going to do that until we actually know the answer to that.

And in the short term, we could absolutely have 25 percent tariffs imposed for one day, one week, one month. And USDMXN and USCAD could print new highs.

So I really just compare it in the broad picture of what's priced in, where we are, how far we come from, and try and trade it that way.

TG: I want to pivot somewhat, still sticking with the tariff theme a little bit. It's amazing. I haven't really talked about it on the podcast too much, so I'm kind of making up for lost time here with you. But I do want to pivot and use tariffs as a talking point around fiscal policy, because one of the things that has been mooted is, well, not just mooted by others, but by Trump himself, is that these are revenue generating exercises that will help to pay for tax cuts.

Lee Ferridge, my colleague, has written about this and about the potential upside for revenue generated from tariffs. And it all potentially fits in with a fiscal framework, which I think is probably nicely summarized by the new Treasury Secretary, Scott Bessent's 333 plan.

So this is reducing the budget deficit to 3 percent, increasing oil production by 3 million barrels a day, and real growth of 3 percent.

Thinking about this first in the context of tariffs, is this a revenue generating exercise that is of substance in contributing towards that goal, do you think?

PV: Yes. How much it can contribute, I'm not sure, but I definitely think is part of the equation. And let's just focus on the 3 percent deficit rule. I think for me, this is the most important variable that we should follow and track this year in terms of our outlook for how the economy in the US is going to evolve. I think tariffs on their own are no way near enough to get there. But I think it's the intent is what I'm focusing on there.

And when I look at the markets post-COVID, fiscal policy has been a massive driver. You know, when you're running a 6 percent fiscal deficit, it's very hard for the US economy to come into recession. And so despite the rate hikes, I think the fiscal side is really, was the other half of the equation that kept the economy humming along nicely. 

This deficit target, I think, is absolutely crucial for the bond market, for how the economy is going to play out. And it's certainly what I'm focusing on this year.

I think the Doge projects, again, none of these are enough on their own. But collectively, they could go quite a bit of the way of getting there.

TG: Overall then, how realistic do you think, taking all of these measures that you've mentioned, whether it's tariffs or Doge, we're going to be pushing in the opposite direction when it comes to tax cuts and how that can potentially grow the deficit.

The 3 percent target, do you think ultimately, this is achievable in two to four years’ time?

PV: It's a tall order. The biggest thing is getting interest expenses down. And I think getting yields down along the curve is going to be a big part of that. And that could easily happen because the economy slows down. But that's going to, you know, the automatic stabilizer means spending probably picks up and you tend to run a bigger deficit if the economy slows down. So I think it's very hard.

But I do think if the direction of travel is correct, the market will reward them with lower yields. If the deficit comes down as well, the Fed can lower rates so they get help from there. And then on the programs, we talked about the tariffs, but on Doge, people are sceptic about how much Musk can cut.

All I'd say is betting against Elon Musk has been a losing strategy. By one measure, which is, you know, monetary accumulation, he's the most successful man in the world. I'm not prepared to bet against Elon Musk and this administration.

And one thing I learned from Trump's first time in office was that having too many preconceived ideas about what you think probably wasn't the best way to trade it. It was to go with what's happening, to try and pick through it and, you know, see how successful they're being. And I'm trading it much, you know, from a much different standpoint this time around. I'm prepared to give the administration the benefit of the doubt. I'm not going to bet against Musk or Bessent.

And I think Trump's very smart, and he understands that he needs long end yields down, which is probably why he's not berating Powell all the time. And he understands that it's actually counterproductive on that front. So, yeah, I'm not going to bet against the administration. I think it's a very tall order, but I do think they're going to do everything they can to try and get there.

TG: You brought up the notion of it being difficult to have a recession when deficits were as large as they are and were. I think one of the internal contradictions one can see in the 333 plan is getting the deficit to 3 percent makes the probability of getting 3 percent real growth potentially less attainable.

How do you think those two coexist?

PV: No, I mean, you've hit the nail on the head. Very difficult. I think getting the growth side of it, that's going to be the bit that loses out to me if they get the deficit down.

The level of monetary policy where it is if we take rates as being restrictive as they are, and then you start having the deficit fall, this, you know, the US exceptionalism story is probably going to end quite quickly, and the economy will start to slow down. So it's really just a case of how quickly the Fed can bring rates down to kind of help with that side of it.

So what I'm kind of as a framework and thinking what will probably happen is we stay higher for longer for the first half of the year, as you know, the tariffs push up inflation and the economy goes sideways. But in the second half of the year, if they make any progress on the deficit, I think the economy will start to look quite weak and I'll be trading it from that side. That's kind of my base case at the moment.

TG: Okay, that's perfect because actually the Fed was the one variable I wanted to really bring into this because so far, at least they well, I think you can get the impression from them that they don't quite know what to make of this. They've been a bit back and forth over the last six months. And the message from Powell last week was really, they're in no hurry to ease rates further.

And we've seen inflation stickiness over the last month and particularly the data on CPI and PPI at least. The components that go into PCE, the Fed's inflation target, maybe don't look as bad, but CPI still looks a little bit sticky.

And I wanted to think about Fed policy in the second half of this year then, when you see there potentially being a slowdown. The median expectation in the Fed dots is two cuts.

Do you think that's about what we'll get in the second half of the year? Or is it going to be even deeper than that with the growth slowdown that you're bringing up?

PV: We don't know the result of the tariffs. We don't know how many people they might deport. Inflation could end up above 3 percent for a while. There's so much water to flow under the bridge.

What I'm thinking is probably roughly in line with the market at the moment in that the policies hold rates higher for longer. The market is priced currently, just to say, if we take it at the moment, we're priced at 40 basis points for the December meeting. It's literally probabilities.

Even with those policies, unless they're extreme, the Fed will probably manage to hold rates for quite a while. I don't see the need to hike from here. So the market is basically just saying, okay, there's a probability that we end up flat all year based on higher inflation, but there's a big potential downside from the outcomes that I just laid out before. So I think we're just trading the probability now.

My base case is that the tariffs, they get put on, they are a revenue tool, but it doesn't push up inflation too much. It holds the Fed where they are until mid-year. But by then, the economy underneath is actually starting to weaken quite rapidly, and that's when we see more cuts in this price into the market. We get a situation like we had in September 24, where the Fed starts looking at 50s again, and we might get rates down to 3 percent.

So I definitely think there's scope for much lower rates, but there's a lot of water to flow under the bridge before we get to that point.

TG: Yeah. Speaking of areas of the world where there's a lot of water to flow under the bridge, I wanted to pivot now to Europe.

And thinking back to the introduction I had and the first few things we talked about with respect to the dollar, European assets, European currencies have actually started the year pretty well. European equities, as I mentioned, have outperformed the S&P by about 8, 9 percent, which I don't think was on anybody's radar at the start of this year.

Some of this, I think, is down to the administration in the US in that we seem to be pushing towards a resolution to the Ukraine war. Whether one accepts or likes the ultimate outcome, I think is still anybody's guess, but the removal of that war risk premia does seem to be giving European assets a boost.

How realistic do you think it is for this boost to last or maybe even to increase even further?

PV: Trump definitely wants a solution, that's for sure. And I think the market's reaction is a bit like, referring back to the first time he came in, the market had preconceived ideas about what happened, and then traded the outcomes as they came out. And last time around, he literally followed his policies. And if you read his policy document before he came in, that would have given you a roadmap.

And I think the market has just been putting on trades where it's fairly obvious he wants a resolution to this. And I think the outperformance has mainly been in industrials and in banking in Europe. We know he wants Europe to spend more on defense. And that's potentially going to happen regardless. Even if we get a solution to Ukraine, Europe's going to need to up its defense spending because it's going to have to be the potential policeman of any deal.

So I think the way the markets reacted there is kind of the safe bet. Even if nothing comes of this, Europe's still going to be spending a lot more money on defense.

And then