Trading Trade And A ‘Spiral Away From Equilibrium’

If there’s anything market participants should have learned over the past nine months, it’s that trading on trade headlines (pun not so much “intended” as unavoidable) is an exercise in abject futility.

Even in a scenario where both sides were rational and everyone entered negotiations on equal footing, attempting to parse every piece of incremental news and every soundbite for clues about how things are likely to turn out would be wholly impractical. When one side (the US) isn’t rational (by virtue of who’s in charge) and the other side is hyper-rational but playing by a different set of rules (China), the equation is impossible to solve.

Domestic political considerations and Trump’s concern for the performance of US equities provide something that approximates a framework for understanding the US president’s decision calculus. But thanks to the fact that Trump’s appeal with his base rests in part on the perception that he’s perpetually “fighting the good fight” (even when that entails harming the very people who came out in droves to vote for him), it’s never entirely clear whether he’s chasing the elusive target – at best pursuing a “win” with China so he can turn his figurative guns on Europe, and at worst negotiating in bad faith, comforted in the notion that his supporters revel in the “us versus them” narrative.

As far as the stock market is concerned, Trump views rallies as opportunities to “play with the house’s money”, as it were. The higher stocks go, the more scope there is for doubling down on a hardline approach both to trade talks and foreign policy more generally.

Administration officials have variously attempted to play down the idea that the market dictates the tone of trade discussions with China, but everyone knows that’s a lie. When you consider the scope of the rally off the December lows and the very real possibility that the Fed’s dovish pivot in 2019 signaled that the central bank is now beholden to the White House, you come away thinking it’s going to take more than one 400-point down day for the Dow to deter this president, especially if he believes that the details of the prospective deal might have made him look weak had he tolerated China’s “amendments”, as reported on Wednesday by Reuters.

Trump obviously felt compelled to weigh in on the turmoil across markets on Wednesday, but his tweets were vacuous compared to the very real threat of a tariff escalation at a pre-determined time on Friday.

“The reason for the China pullback & attempted renegotiation of the Trade Deal is the sincere HOPE that they will be able to ‘negotiate’ with Joe Biden or one of the very weak Democrats, and thereby continue to ripoff the United States (($500 Billion a year)) for years to come”, the president remarked, in an assessment that probably contains some kernels of truth, although if China were angling to put a final deal off for another 18 months, it seems unlikely they would have come as far as they have towards meeting in the middle.

Trump continued, suggesting that China “informed” the White House that Liu He intends to “make a deal” on his trip to Washington this week. There’s likely nothing to that claim. What would the opposite of that assessment be? Maybe “China has just informed us that the Vice Premier is flying halfway around the world not to make a deal?”

Sarah Sanders tried to provide some cover. “We have gotten an indication they want to make a deal, our teams are meeting with their team tomorrow, we will see what happens”, she told reporters. Meanwhile, Trump continued to insist that “over $100 Billion a year in Tariffs [are] filling US coffers.” That’s not true. The tariffs are a tax on consumers. Everyone (likely including the president) knows that.

For their part, China reiterated that Beijing would be forced to “adopt necessary countermeasures” come Friday, if Trump doesn’t swerve in this game of chicken. “Escalating the trade conflict is not in the interest of the people in both countries and the world. China deeply regrets the move”, the Commerce Ministry said in a statement, which came across as far more sincere than anything Trump has ever said about this scenario.

In a note dated Monday, BofA uses a simple framework to model the relationship between markets and policy. In the visual below, the bank illustrates the market’s response to policy with an upward-sloping line (the more benign policy is, the more positive the market response and vice versa). The downward-sloping line shows the policy response to markets where, quote, “weak markets motivate friendly policy and strong markets do the opposite.”

(BofAML)

If you think that looks familiar, you’re correct. Here’s BofA:

This framework is not entirely new. It is conceptually similar to traditional countercyclical monetary and fiscal policymaking. For example, markets are stronger when they expect a dovish Fed, but strong markets (and a strong underlying economy) tend to make the Fed more hawkish. But there are a couple of important differences between traditional countercyclical policy and countercyclical protectionism.

What are those differences? Well, policy is more rigid and slower to shift given that it responds to economic outcomes (observable or predicted) which are less volatile than markets. The bank notes that thanks in large part to Trump’s penchant for market watching, apparent shifts in trade policy are more frequent.

BofA also quips that “it is somewhat ironic that trade policy has become countercyclical after a large procyclical tax cut and a somewhat procyclical turn in monetary policy.” Ironic though it may be, it’s not a coincidence. Procyclical fiscal and monetary policy free up space for aggression on trade.

The second difference, according to BofA, is that “standard monetary policy is… well understood by the markets and gets priced in before the fact.” That suggests that a new equilibrium will quickly materialize as the market adjusts to expectations for monetary policy based on the incoming data.

The bank then asks a question that’s particularly germane this week – namely, “What if markets do not understand how policymakers will respond?” Consider this, from BofA’s analysis:

…Chart 4 shows in our view how the new equilibrium might be reached. Stronger markets lead to less friendly policy, which weakens the markets, which leads to more benign policy, and so on. In other words, markets will gyrate on the path to the new equilibrium. But there is an even more concerning possibility. What if, instead of converging to a new equilibrium, markets and policy spiral away from it, as in Chart 5? That is, what if each move in the markets causes an increasingly larger policy response, and vice versa? In that case we think market volatility will be exaggerated, and equilibrium will only be reached when the markets “learn” the policy response function. The difference between Chart 4 and Chart 5 is the responsiveness of the policy function. It is precisely when policy is very responsive to markets that we might spiral away from equilibrium instead of converging to it.

The upshot (in case it’s not clear enough), is that if the market cannot figure out Donald Trump’s reaction function when it comes to trade policy, we risk a scenario akin to what you see in the right pane.

The response in Chinese equities (and the yuan) on Monday and Tuesday’s mini-rout on Wall Street suggest the market does not yet fully understand what’s going on inside the US president’s head at any given time. In that regard, markets are in the same boat as the president’s aides, advisors and, perhaps most disconcerting of all, Trump himself.