It’s the damndest thing.
The leader of the free world has a super hero name for himself and it’s “Tariff Man“, a state of affairs you’d think would be conducive to inflation. As it happens, Tariff Man has a penchant for pro-cyclical fiscal policy that borders on the fanatical. Again, that should be conducive to inflation, as piling fiscal stimulus atop a late-cycle dynamic when unemployment is parked at a five-decade nadir is tempting fate, assuming the Phillips curve is “just sleeping” (and not “gone to meet its maker”, like the Norwegian blue). And “Tariff Man” is also engaged in an around-the-clock effort to commandeer monetary policy, which he’d like to be pro-cyclical too. One more time: That should be conducive to inflation.
But it’s not that simple. Because Tariff Man really meant it when he said his tariffs were the “greatest” tariffs. Trump’s isn’t a half-hearted protectionism. Rather, Donald Trump appears pot-committed to instigating an all-out, global trade war. The demand destruction that would likely accompany this fool’s errand for the ages, argues against inflation and the fact that Tariff Man happens to run the country that prints the world’s reserve currency adds an additional layer of complexity, because too much dollar strength is deflationary.
And so, here we are, staring down an absurd scenario befitting of these absurd times.
On one hand, the US is about to slap tariffs on the entirety of Chinese imports and may well tax European and Japanese cars. And yet thanks to the sheer scope and brazenness of this quixotic crusade to tilt at the trade deficit windmill, the world is teetering on the brink of a global economic downturn. Fears of an economic cataclysm and the assumption that central banks will be forced to respond accordingly, have led to a renewal of the late-March growth scare and accompanying bid for DM bonds.
When it comes to what Nomura’s Charlie McElligott on Thursday described as “the current group-think consensual embrace of the Slow-flation/End-of-cycle slowdown story”, suffice to say “the force is strong with this one.” For instance, JPMorgan’s Treasury survey shows client outright longs at the highest since 2010, Nomura’s risk parity model betrays a 3-standard deviation DM bond allocation and since the Fed’s dovish pivot in January, global bond funds have seen some $160 billion in inflows.
(Bloomberg, Nomura, EPFR)
That, against Tariff Man’s forthcoming “greatest” escalations, the assumed Chinese policy response and a Fed that would really like to believe that come hell or high water, they’ll be able to push inflation sustainably to target, even if that means overshooting to “make up” for shortfalls.
If the Trump administration goes ahead with tariffs on the entirety of Chinese exports to the US, Beijing will almost surely be compelled to resort to a more aggressive stimulus approach. If it works, that’s reflationary. Meanwhile, an all-out global trade would drive up consumer prices. At the same time, the Fed is engaged in an ongoing policy framework review which most observers expect will eventually produce a “new” approach to inflation. And then there’s the prospect of rate cuts (priced in by the market, if still downplayed by the Fed itself).
Contrast that with the massive duration long/bond “love affair” and you can see where the “problem” might come in.
“What can drive yields higher? Inflation, which nobody in the investing universe believes is an actual ‘thing’ anymore”, Nomura’s McElligott asks and answers, before imploring you to think about the setup outlined above. Here’s how he puts it:
But think about this: if the base case has now shifted to “the fourth tranche of tariffs are coming”—domestic inflation is going higher, as these taxes are passed onto the consumer. And mind you…this is coming at a time where the PBoC and Chinese authorities are forced to “keep the pedal down” on their own easing and stimulus measures…while too, the Fed remains under obvious pressure regarding their inflation framework (and into the June Fed research symposium where “Reflation” will be back in the news rotation).
If inflation, left not only for dead, but now almost antiquated as a concept (i.e., for many market watchers, inflation isn’t even a thing that is real anymore, hence the constant lampooning of DM central banks who are perpetually chasing an ever-elusive target), were to come roaring back, sparking a bond selloff against the consensus positioning detailed above, you’d have a “combustible” situation that “could get weird”, Charlie warns.