On Wednesday, global markets calmed down a bit after a couple of tumultuous days spent pondering the sheer blatant disregard for international norms inherent in the Trump administration’s trade escalations.
Generally speaking, everyone is (still) clinging to the assumption that someone will swerve in this increasingly dangerous game of chicken. As ever, that assumption is at least in part predicated on the idea that Trump wants to find the optimal mix of rhetoric/action that will allow him to bolster his “tough on trade” credentials while preserving the equity rally.
Finding that optimal mix is key ahead of the midterms and in light of the burgeoning border crisis, it’s even more critical from a political standpoint that Trump avoids accidentally triggering a market collapse by pushing the protectionist envelope too far. That is, to the extent this is all (or mostly) political gamesmanship designed to bolster the GOP ahead of November, Republicans are already under pressure from the bad optics around the “zero tolerance” border policy, so just about the last thing they need is for Trump to get blamed for a stock market crash that’s traceable to the trade war.
In the same vein, the administration needs to be careful when it comes to the next round. That is, assuming the initial levies on $50 billion in Chinese goods do indeed take effect, Trump needs to be wary of publishing a second and third list, targeting $100 billion or $200 billion in additional Chinese goods, because those lists would invariably include consumer items and that entails pushing up prices. If OPEC is ultimately unable to bring about a sustainable drop in crude prices in the back half of the year, it’s conceivable that higher prices at the pump could collide with higher prices on consumer goods, at a time when the Fed is predisposed to leaning aggressively hawkish for fear of falling behind the curve as late-stage dynamics bring the Phillips curve back to life. In other words: Trump needs to be cognizant of the stagflation threat.
Of course the Fed will likely try and look through the possible downside from the trade conflict (i.e., assume it will pass) and that means that in the initial stages of escalation, the curve would likely continue to flatten as the market assumes the Fed will stick to its rate path while risk-off flows and the stronger dollar are supportive of the U.S. long end.
I’ve been over this before, but BofAML is out with a new rates and FX piece in the context of the tariffs and it’s worth reiterating the dynamics in light of this week’s news.
“US Treasury rates would likely decline with a further material increase in trade tensions [as] rate declines would be led by risk-off dynamics and lower growth expectations”, the bank writes, in a note dated Wednesday, adding that “the initial response from the rates market would be to price in a flattening of the curve as the front end responds to tightening while 10y and 30y rates remain low due to declining growth expectations and a lower pricing of the terminal rate.”
So that’s the near-term reaction. But if this crazy shit persists for too long, we run into a scenario where the Fed starts to reconsider based on a more dour outlook for growth. Here’s BofAML:
Medium term: the Fed may need to reduce the total number of rate hikes over the course of this cycle and realize a lower terminal rate. Although tariffs will likely place near-term upward pressure on inflation, we expect the Fed will look through this dynamic and instead focus on underlying softening global growth and consumer demand. This would pose risks to the number of hikes the Fed delivers in 2019 or 2020 and result in a lower terminal rate for this cycle. This assumes any near-term tariff-induced increase in the price of goods would be expected to be short lived and not spill over into longer-run inflation expectations, which is our base case view. If trade tensions result in a rapid escalation of tariffs and protectionist policies, a severe trade war could suppress growth and potentially cause the Fed to consider rate cuts.
Ok, now here’s where the real problem comes in. There are a couple of different ways this could pan out. It’s possible the Fed waits too long to change course and ends up tightening into a global slowdown and thereby exacerbates the situation, inverting the U.S. curve and pushing the domestic economy into a recession. The likelihood of that happening increases commensurate with upward pressure on wage inflation (late-cycle dynamics supercharged by expansionary fiscal policy), the assumption that even without fiscal stimulus, the Phillips curve will reassert itself anyway at some point and the worry that inflation expectations will become unanchored as a result of higher oil prices and a tariff-induced rise in consumer prices (even if the Fed doesn’t explicitly acknowledge that, it’ll be something they debate internally).
Now, in the event we did get a slowdown or a recession triggered in part by an overly aggressive Fed and in part by a deceleration in global growth catalyzed by a tit-for-trade war, well then the risk is that Powell starts cutting rates to combat the downturn against a domestic backdrop defined by a deteriorating fiscal position and high inflation. That raises questions about sponsorship of the U.S. long end. There’s more on that in “Behold: An ‘Incubator For Vicious Steepeners’“, but here’s BofAML with a bit more color on reserve manager demand in an environment characterized by slowing global growth:
Trade tensions are likely to result in weaker UST demand from foreign central banks due to slower FX reserve build and less likely due to trade retaliation. From a flow perspective, a key channel between trade tensions and rates is reserve manager demand. Foreign investors accumulated roughly $6.2tn of US Treasuries over two decades as a result of international trade and market intervention, and $4tn of them are held by reserve managers. China and Japan are the biggest creditors of the US government, holding about 7% of overall marketable Treasury securities each. According to the latest TIC survey, foreign central banks hold mostly front-end to intermediate maturities. After an immediate risk-off episode, the medium-term reduction in bilateral trade deficit between the US and China should result in a slowdown in China’s FX reserve build, resulting in lower Treasury demand from China. Lower global trade volumes should result in a slowdown of global reserve accumulation, less central bank demand for USTs and upward pressure on interest higher rates (Chart 2).
Note how BofAML says it’s “less likely” that reduced demand for USTs would be the result of FX reserve managers effectively weaponizing their holdings. The bank goes on to elaborate on why they think that’s less likely and they also suggest that an ongoing escalation in the trade conflict would “accelerate USD appreciation that is already well underway as a result of cyclical and monetary policy divergence, with the added boost to the dollar essentially a function of the severity of perceived global trade deterioration.”
Those two contentions (i.e., the assumption that reserve managers wouldn’t weaponize their UST holdings and the idea that the dollar will rally sharply) could ultimately prove to be misguided. While I won’t weigh in here on a given country’s (read: China’s) propensity to sell USTs in retaliation for trade escalations, what I would gingerly suggest is that if the Fed is forced to cut rates against a backdrop of a deteriorating U.S. fiscal position and rising domestic inflation, it’s not at all clear that the dollar would indeed hold up, irrespective of whether rate differentials still optically favor the greenback.
So you know, just more of Heisenberg’s random musings that may or may not be cogent/useful. Take them for what they’re worth (or not worth).