Two weeks ago, in “Cheshire Cat’s Smile: ‘What Is The Fed Worried About?’”, I regaled readers with some of my patented island anecdotes on the way to warning folks about the perils associated with trying to discuss the Phillips curve at local bars.
Somehow, I managed to segue from that into a some excerpts from what, at the time, was the latest from Deutsche Bank’s brilliant Aleksandar Kocic who, three Fridays ago, delivered a Phillips curve history lesson complete with the following color and accompanying visual:
Through the last four cycles, Phillips curve has asserted its importance in an unorthodox way and, as such, attained a special status; it inhabits a space different from other macroeconomic frameworks and metrics. In each cycle, it falls apart, but after every annihilation, it re-composes itself and continues to play an important role. It appears “indestructible”, but not in a conventional way, more like a survivor of one’s own death. Phillips curve functions like an organ without a body, an equivalent of Cheshire cat’s smile (in Alice in Wonderland) that persists alone, even when the cat’s body is no longer present. This time is no different in our view. The figure shows the Philips curve through several cycles starting in mid-1980s. Each cycle has a different color which implicitly marks their beginning and end. The first thing one observes is that this is more of a “spaghetti” then a curve. The main reason is that it captures different cycles — a testimony to its falling apart and recomposing itself after each.
The implication there, clearly, is that Fed is likely concerned that should they deviate from their (relatively) hawkish course, they could get caught flat-footed by a suddenly not-so-flat Phillips curve.
If they were then forced to hike aggressively, they risk a scenario where they hike the economy into recession but inflation fails to respond quickly to the change in monetary policy. In other words: they risk stagflation.
Naturally, the course of U.S. fiscal policy and the threat of a global trade war makes those worries all the more vexing.
On the fiscal policy front, piling stimulus atop a late-cycle economy raises the risk that inflation will suddenly materialize as we reach a tipping point beyond which the left-for-dead Phillips curve jerks back to life like the villain at the end of an 80s slasher flick.
As far as how the trade war factors into all of this, I discussed it at length utilizing some quotes from a recent Barclays note in a followup to the post mentioned above called “The Real Estate Developer, The Chinese Strongman And Cheshire Cat’s Smile“. Here are some excerpts from that:
Consider that in the context of the tariffs and, more broadly, in the context of the effort to roll back globalization.
“Economic theory suggests that globalization is likely to have had a negative effect on inflation both in terms of its level as well as its volatility,” Barclays writes, in a note dated June 7. They cite four factors to support that contention, one of which is the idea that “trade can increase price and wage flexibility domestically, leading to a flattening in the Phillips curve.” Here’s some technical work:
Figure 8 shows different specifications of a reduced form Phillips curve involving domestic and foreign variables, pooled across G10 countries over two sample periods, 1985-2003 and 2004- 2016. The inflation-domestic output gap sensitivity has declined substantially, whereas the sensitivity to external prices (import prices) and the global output gap has increased, coinciding with the period of rising globalization. Figure 9 confirms that inflation has been negatively related to openness for a number of G10 and EM countries, but this sensitivity is particularly low among G10 countries (Figure 10). We find that increased openness has coincided to the decline in inflation globally, even after controlling for output gaps and central bank independence in a pooled regression.
While they do note that EM is more sensitive to these dynamics than DM, the takeaway is that, quote, “a reversal of trade integration/openness trends implies a steeper Phillips curve, increased sensitivity to domestic economic conditions, higher inflation outcomes in the long term (all else equal) and higher inflation volatility.”
So is it possible that Trump’s policies will exacerbate the late-stage Phillips curve dynamics described by Deutsche Bank’s Kocic?
It would appear so, and you can bet the Fed is cognizant of that possibility.
Needless to say, the trade situation has deteriorated further since I wrote that post a couple of weeks ago, and when it comes to the question posed there (i.e., “Is it possible that Trump’s policies will exacerbate the late-stage Phillips curve dynamics described by Deutsche Bank’s Kocic?”) the answer is definitively “yes”.
And I know the answer is definitively “yes”, because Kocic himself says as much in his latest weekly note, dated Friday. To wit:
The economic impact of tariffs and trade wars is twofold: they are bearish for growth and supportive for inflation. On our estimates, if the current administration’s proposal is taken at face value, it would reduce US GDP growth by 3/10 and push PCE 0.15% higher. The effect of such an outcome is steepening of the Phillips curve, a property that the Fed has been watching very closely.
The Fed has a quandary here. If they opt to stick to the course in order to fight inflation, well then they risk sitting idly by as trade tensions weigh on growth. Powell addressed this in Sintra last month, noting that “changes in trade policy could cause us to have to question the outlook [and] for the first time, we’re hearing about decisions to postpone investment [and] postpone hiring.” For what it’s worth (which is nothing), Wilbur Ross and his proprietary soup can index think that’s bullshit.
On the other hand, if the Fed attempts to preempt any negative impact on growth from trade by delaying hikes, they risk confronting a suddenly steep Phillips curve from a dovish position.
So, they are likely to stay the course until the trade tension’s impact on growth can no longer be ignored and that is, in the near-term, a recipe for curve flattening. “Unlike the ECB, the FOMC is looking through the external risks, comforted by the positive impact of the fiscal stimulus on the economy,” Deutsche Bank wrote, in a separate note from last month. “The front-end is unlikely to rally substantially as long as the impact of the trade concerns remains muted, the curve is likely to bull flatten in moderate risk-off scenarios,” they continued.
This is complicated immeasurably by the fact that nobody knows what Donald Trump is thinking. With each passing escalation (be it reports that the administration is considering going the 1977 International Emergency Economic Powers Act route when it comes to restricting Chinese investment in U.S. industries, reports that Trump is still talking about exiting the WTO, etc.) it appears that Trump is actually serious about starting a trade war of attrition as opposed to simply using bombast as a means of bolstering the GOP ahead of the midterms. Here’s how I described this in a hilarious post for Dealbreaker earlier this week:
On Monday, global markets overdosed on “covfefe” — again.
This happens from time to time, and usually, someone comes along with some Naloxone before things spiral completely out of control.
Trump didn’t invent inflammatory Twitter rhetoric, nor was he the first politician to move markets with social media posts. But — and this is the important part — he was the first person to master the process of extracting pure “covfefe” from nonsensical tweets, and his product is potent as hell.
The GOP is effectively betting the midterms on Trump being able to administer that product in a way that keeps the base high as a kite but avoids accidentally killing risk assets. That’s a fine line and one of the problems is that Trump doesn’t take into account the possibility that destabilizing news might come from places other than his Twitter feed when he goes about deciding how much unadulterated, uncut, “covfefe” to dole out on a given day.
For their part, BofAML has thrown in the towel on this:
— Heisenberg Report (@heisenbergrpt) June 22, 2018
Long story short, last week’s market action seems to suggest that folks are starting to get worried about the possibility that Trump’s trade “strategy” entails something more than simply rallying the base ahead of the midterms.
Well, in the same new note cited above, Deutsche Bank’s Kocic takes on the task of developing a tariffs decision tree on the way to analyzing the various embedded contingencies, both political and economic. He begins by differentiating between the tactical and the strategic, where the former refers to the tariff threat as political leverage and the latter describes trade restrictions as part of an actual economic strategy.
How do we think of the impact of tariffs on the markets in the absence of clarity in the near term? There are two dimensions that describe contingency of the problem: tactical bias and mid-term elections outcome. At the moment, neither is known. The tactical bias, denoted as p, reflects to what extent the talk about tariffs is used as a tool of political leverage: p = 100% corresponds to tariffs’ usage as purely tactical, primarily in the mid-term elections, but also beyond that, while p = 0% corresponds to a strategic view — tariffs are meant to stay and are used as part of a broader economic strategy, not directly motivated by politics. The probability of Republican and Democratic victories in the mid-term elections is denoted with q, and 1-q, respectively.
In terms of two probability parameters, p and q, the likelihood of persistent tariffs and their withdrawal or reduction is:
From there, Kocic notes that “if everything is 50/50 (no particular bias: p = q = 50%), the outcome is 75/25 in favor of permanent tariffs [as] the tariffs emerge as permanent in three of four possible states.”
Here’s the visual on that:
The point there is that the midterms are seen as a coin toss and the assumption going in is that the tariff issue is 75% political leverage and 25% “real” (as it were). That’s probably about right. After all, Donald Trump is (at least) 75% bombast and (at most) 25% serious, so there’s no reason to assume that split should be any different when it comes to trade.
But as Kocic notes, “even if tactical bias is high (75%), the probability of persistent tariffs still leans towards their permanence.” Here’s the bottom line:
Depending on the elections’ outcome, the tariff story can be dialed up or down. A strong tactical bias would imply that current rhetoric behind tariffs can be dialed down under more favorable political circumstances. Tactical bias changes across the elections — only if Republican victory is certain does it remain unchanged. Assuming that the bias is purely tactical, it can change to strategic or can be dialed up if Democrats win. If tariffs are strategic, reflecting a shift towards a change in global economic policies, they should persist irrespective of short-term political developments.
What does this mean for markets? Well, obviously this isn’t likely to resolve itself completely ahead of the midterms and that, in turn, means that everyone will remain on edge. But in the absence of an acute shock to growth and or an outright collapse in risk assets that tips a crisis of confidence, the Fed will likely persist.
That means more curve flattening and a continual migration of vol. to the front end. “This should be collinear with a continued rise of front-end yields and stability or downward pressure on long rates,” Kocic says.
As far as stocks go, it’s the same story: lingering fear. Global markets are not digesting the trade tension well and to the extent U.S. equities do manage to decouple and climb higher, it will likely be, as I put it a few weeks back, a “slow, arduous walk”.