A man walks by a wall of currency at Frost Bank. Photo by Scott Ball.
A man walks by the "Money Museum" at Frost Bank, a collection of coins and currency dating back to 1536. Credit: Scott Ball / San Antonio Report

The outcome of the 2016 presidential election was a surprise to many.

Since the election, media outlets across the nation have been asking the same question: “How could the polls have gotten it so wrong?”

Forecasting methods like PollyVote, which draw from non-polling data, missed the Electoral College result while correctly predicting that Clinton would win the popular vote).

Interestingly, prediction markets such as Iowa Electronic Markets, which have been the “new thing” in election forecasting and typically have been the most accurate, produced the worst forecasts in this election, while econometric models, which had been the least accurate over the past six elections, did the best.

It’s safe to say that combining forecasts from different methods generally leads to better predictions over time than relying on any single method. Of course, in any single election or forecasting event even a coin toss will be right half of the time. So be on your guard, because this is where the hucksters come out of the woodwork touting their particular model’s success as a prelude to pitching you this or that investment product.

A key economic outcome of the election should be a pick-up in business investment spending and, hence, economic growth, which have been historically low during this expansion. On the demand (for investment funds) side, that’s largely because President Obama was viewed as more anti-business than either Trump or Clinton, and that tended to keep money on the sidelines.

On the supply (of investment funds) side, some regulatory clarity and simplification on Dodd-Frank banking legislation is likely going forward. It is widely acknowledged that the evolution of this particular legislation has thwarted credit creation, or the banking system’s ability to serve as a financial intermediary matching capital with opportunity. In fact, both candidates expressed the need for reform or fixes to major legislation like Dodd-Frank, so the likelihood of stronger investment spending – and, hence, growth – going forward would be higher regardless of who won the election.

As for the Federal Reserve, I would say that Federal Reserve Board Chair Janet Yellen has had to face a conundrum with regard to raising rates. If the Federal Reserve acts to push short-term rates up, while global capital flows act to keep longer-term rates down (by bidding up the price of longer-term bonds and lowering their yield), then the result would be a flattening of the yield curve.

The yield curve is nothing more than a chart that plots short-term interest rates against longer-term interest rates. Longer-term rates are usually higher than short-term term rates: it is riskier to loan money longer-term than shorter-term, so long-term lenders require higher rates to compensate them for this increased risk. That’s what it means to have a normal, “positively sloped” yield curve.

Now, banks tend to borrow short-term funds and make long-term loans, and they make money off the “spread” or difference between the two, which is why analysts often refer to them as “spread businesses.” Steeper yield curves, thus, tend to help banks, and flatter yield curves tend to hurt banks because the spread between what banks pay for funds (short rates) and what they earn on them (long rates) is smaller.

Hence Yellen’s conundrum: raising rates and possibly flattening the yield curve could hurt banks, but with a stronger growth outlook going forward and less risk of disinflation, I believe there is a greater tendency for longer rates to rise. Indeed, we’ve seen that happen since the election, making it easier for the Federal Reserve to raise short-term rates.

So the election has actually increased the odds of the Federal Reserve raising rates, which is reflected in the federal funds rate futures markets.

That’s not the only way to reach that conclusion, however. One could also make the case – and many have – that higher deficits under Trump will lead to higher rates. But after more than 20 years of looking at interest rates and deficits, I’ve concluded that there is no reliable relationship between interest rates and budget deficits/debt in the U.S. data.

Jim Kee

Jim Kee, Ph.D. joined South Texas Money Management at the beginning of 2009 and serves as president and chief economist. His expertise lies in combining top-down, macroeconomic insights with bottom-up...