Just after 8:30 AM on Tuesday, Donald Trump sent his eleventh tweet of the day.
“China will be pumping money into their system and probably reducing interest rates, as always, in order to make up for the business they are, and will be, losing”, he said. The president then implored Jerome Powell to join the trade war. “If the Federal Reserve ever did a ‘match’, it would be game over, we win!”
A couple of financial news outlets suggested that was the first time Trump had overtly called for the Fed to lay down some cover fire. It wasn’t – the first time that is.
Last summer, following his landmark interview with CNBC’s Joe Kernen, Trump tweeted multiple times about the extent to which relatively hawkish US monetary policy was watering down the effect of the tariffs by keeping the dollar strong. There was rampant speculation the administration might actually intervene in FX markets.
In addition to that, Trump’s calls for Fed cuts and the cessation of balance sheet runoff are motivated in part by a desire to marshal the central bank in the trade conflict.
The latest tariff escalation and Trump’s subsequent decision to blackball Huawei look to have made the Sino-US dispute intractable. China is dug in. The Party’s propaganda mouthpieces are channeling Mao, calling for a “People’s war”.
If Xi doesn’t blink in the face of the USTR’s threat to slap tariffs on another $300 billion of Chinese goods, Trump will have painted himself into a corner. Things will escalate. China will respond. Stocks will sell off.
Since early 2018, the market has rebelled against Fed hikes. The “uprising remains as an illustration of the Fed’s addiction liability post-QE”, Deutsche Bank’s Aleksandar Kocic wrote Friday.
You might recall that last year, Kocic quite literally nailed the S&P. Based on his framework for analyzing the restriking of the Fed put and, at a higher level, his take on the Fed’s transition from convexity supplier to convexity manager, Kocic argued on multiple occasions in 2018 that the S&P could fall to between 2,300 and 2,400 before the “Fed put” kicked in.
This isn’t difficult to grasp, conceptually speaking. “When the Fed put is viewed as an insurance of the protection for a long stock position, the distance of its strike from the spot is the value of the deductible”, Kocic wrote Friday, recapping. He expresses this as stocks’ beta to the short rate. “The more accommodative the Fed, the lower the deductible of the insurance and the more compelling it becomes to own stocks”, he goes on to say, alluding to previous notes. “This means that higher beta corresponds to lower deductible, i.e. Fed put strike closer to ATM.”
As things stand now, the Fed put has been re-struck closer to ATM. Note the visual – 2600 is roughly the strike. We’re 10% OTM.
The “Trump put”, some say, is just 3-4% OTM. That refers to the president’s assumed tolerance for lower stock prices. As we’ve seen, there’s a threshold beyond which US trade policy becomes less aggressive in order to stabilize markets.
The risk is that the line between the “Fed put” and the “Trump put” becomes blurred.
In his Friday note, Kocic lays out three possible “destinations” going forward. The first is simply that risk fades and the Fed stays the course.
The second entails the Fed remaining obstinate (some would call it “independent”) while trade risks worsen. Here’s Kocic’s take on that:
This is bearish for equities and possibly bullish for the long end of the curve. This could force the US to tone down its hardline stance on trade, taper its escalation, and possibly stabilize equities lower, while rates remain unchanged, allowing the next stage of repricing to resume after the economy metabolizes the effects of tariffs.
A potentially more worrisome scenario finds the Fed cutting rates in response to the trade frictions. This would be an implicit (or, who knows, perhaps an explicit) acquiescing to Trump’s call for Powell to “match” the PBoC. Here is Kocic explaining why that could be long-term destabilizing:
3) Risk remains constant or higher, but the Fed cuts rates. In this way rate cuts could offset the effects of Chinese central bank and temporarily calm the markets. However, while the immediate impact of this maneuver would stabilize equities, its consequences could be destabilizing. An overly accommodative Fed could encourage further escalation of trade wars with more tariffs on one side and, at the same time, erode Fed’s credibility on the other. Further trade war escalation would act as a negative supply shock causing a higher price level ultimately forcing the US consumer to carry the costs of higher tariffs. In this way, temporary stock market stability becomes destabilizing with the economy suffering from higher inflation and lower output which does not have a proper monetary policy response.
All of that is critical to understand and the latter point especially so. As tariffs put upward pressure on consumer prices and the economy decelerates, the central bank is left with a Sophie’s choice: Cut rates to boost growth at the risk of exacerbating inflation or hike rates to curb inflation at the risk of making a nascent slowdown worse.
“Possible concessions of the Fed, which seems to have produced a temporary relief earlier, could only make things worse, both in the short- as well as in the long-run”, Kocic laments. “We do not see a clear circuit breaker here.”