Nomura’s McElligott Warns On Stagflation, Says Fed May Stumble Into ‘De Facto Hike’

Nomura’s Charlie McElligott picked a helluva week to go stomping around in Asia, and he knows it.

“What a week I chose to be ‘boots on the ground’ in Asia-Pac”, he writes, in the opening line of his Monday missive.

If you’re wondering what the mood is in Asia, Charlie says overall market sentiment is “anecdotally approaching ‘max bearish’ on both global economic prospects and risk assets.” Investors, he says, are starting to come to terms with the reality of the trade war and the distinct possibility that it will drag on into the US election.

As usual, Charlie has an insightful (and somewhat provocative) take on the outlook.

After noting bull steepening on the back of three implied Fed cuts over the next year, he details what he calls “the growing risk of an ‘inflation impulse’ NEGATIVE shock to the [steepener] trade.”

For the setup, we go to the NY Fed’s Liberty Street Economics blog, where Mary Amiti, Stephen J. Redding, and David E. Weinstein wrote the following late last month: 

One way to estimate the effect of these higher tariffs is to draw on the recent experience of the 2018 U.S. tariffs. Our recent study found that the 2018 tariffs imposed an annual cost of $419 for the typical household. This cost comprises two components: the first, an added tax burden faced by consumers, and the second, a deadweight or efficiency loss.

The magnitude of these costs depends on how a tariff affects the prices charged by foreign exporters and the U.S. demand for imported goods. Studies, including our own, have found that the tariffs that the United States imposed in 2018 have had complete passthrough into domestic prices of imports, which means that Chinese exporters did not reduce their prices. Hence, U.S. domestic prices at the border have risen one‑for-one with the tariffs levied in that year. Our study also found that a 10 percent tariff reduced import demand by 43 percent. 

The research referenced in those excerpts is the same as that cited by Goldman last month when the bank detailed how the tariffs have impacted inflation thus far. We summarized that on May 11. As Goldman wrote, “the costs of US tariffs have fallen entirely on US businesses and households, with no clear reduction in the prices charged by Chinese exporters”. Additionally, the bank noted that “the effects of the tariffs have spilled over noticeably to the prices charged by US producers competing with tariff-affected goods.” In other words, exporters are not eating any of the costs and other folks are opportunistically raising prices — who could have seen that coming?

Read more: Here’s What Happens To Inflation In A Worst-Case Tariff Scenario

The risk from this is clear: stagflation. At a certain point, the tariffs will drive up consumer prices. Indeed, if the administration ultimately imposes a 25% tariff on all imports from Mexico along with a 25% duty on everything the US imports from China, up to 80% of some products will be subject to tariffs (e.g., toys, cell phones, and other consumer electronics).

Meanwhile, an all-out trade war is expected to serve as serious drag on global growth. Indeed, that’s what bonds have been pricing in over the past month. Inflation and a sharp downturn in growth is a decidedly pernicious combination.

“The cumulative impact of 1) the expected fourth tranche of China tariffs on top of the prior announced tariff impact, and 2) the assumed full-impact of the Mexican tariffs (going all the way to 25%) sets up the potential for a ‘stagflation-lite’ type of environment”, Nomura’s McElligott says, before citing the NY Fed’s blog post (and, implicitly, this paper), in noting that “new academic research showing a nearly 100% pass-through of the 2018 tariff costs into domestic prices of imports.”

So, how is that relevant to Charlie’s outlook for rates? Well, as you’re probably aware, market participants remain extremely reluctant to accept the idea that inflation is coming back anytime soon. Indeed, most folks don’t even believe inflation is a “thing” anymore (as Charlie put it last month). That means that while markets may be aggressively pricing in a recession (or, at least, an acute growth scare), they are underpricing stagflation.

“In that sense, if ‘stagflation’ is currently being underpriced by a market which remains outright cynical of the prospects for an inflation impulse, the best trade may just be owning front-end Real Yields”, McElligott says, on the way to delivering the following takeaway:

Thus, even as the Rates market continues to press “Fed policy cut” bets to new (unprecedented) levels–the Fed might in-fact be relatively “constrained” in the sense that they cannot cut to the same extent which the market is attempting to price, due to the Committee’s awareness of the impact that the tariffs will have on import prices–so the risk is that this inability for the Fed to keep pace with market pricing could in-fact create a de facto “hike” relative to VERY extended cutting expectations (from a “flow” / “quantum” perspective) and risk generating a Rate Vol event into a market that’s been structurally / systematically shorting Rate Vol for years.

That makes for a very interesting addition to the already complicated calculus for the Fed at a time when multiple banks are calling for rate cuts as soon as next month, but officials remain wary of acquiescing for fear of coming across as enablers of the trade war.

Remember what Deutsche Bank’s Aleksandar Kocic wrote last month. To wit:

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.

If the Fed cuts, it sets the stage for more tariffs and with pass-through in successive rounds likely to be high (the mitigating effect of supplier substitutions – e.g., Vietnam – notwithstanding), the worry is that aggressive easing could be risky from an inflation standpoint. Any boost to growth from rate cuts might well be simply offset by the negative impact of more tariffs, thus making the entire endeavor an exercise in futility at best, and a credibility risk at worst.

McElligott’s point on Monday is that even if the Fed does decide to cut, the concerns detailed above will mean they can’t catch up to market expectations. In that way, the perception that an “insurance cut” of, say, 25bps in September, isn’t sufficient, would amount to what Charlie calls “a de facto hike”.

Read more: Why Fed Cuts Now Would ‘Only Make Things Worse’