It’s not difficult to surmise that the Mexico tariff threat was the proverbial straw that broke the camel’s back when it comes to cementing the case for Fed cuts.
All you really have to do is pull up a chart of market pricing and annotate it for the Mexico escalation. If you slap a chart of the S&P on top, you can clearly see that the squeeze higher and/or dip-buying was catalyzed by rate cut expectations going into hyperdrive.
You’re reminded that the problem with the Mexico tariff threat went well beyond the prospective mechanical impact of the levies themselves. Sure, it would have been bad had the dispute somehow gone unresolved through October leading to a 25% tariff on all imports from Mexico, but the immediate concern for markets was the read-through of the threat for negotiations with China and Europe.
This was best captured by SocGen in their Q3 outlook as follows:
Imposing tariffs on a country with which the US has only recently concluded a trade agreement, sets a very negative precedent in that it suggests to other countries that even if they make concessions and conclude a trade agreement, the US administration apparently does not feel bound by it. This seriously reduces the incentive for any country to negotiate with the US. Why negotiate in good faith, if the US apparently has no intention of sticking to an agreement? This could make it impossible to settle whatever trade disputes the US has with other countries.
In addition to those concerns, the Mexico threat also underscored the extent to which Trump is increasingly prone to blurring the line between trade, economics and national security. As SocGen wrote in the same note, “tariffs are being promoted as a kind of miracle cure for all possible issues that involve another country.”
That the Mexico tariffs were averted didn’t change the fact that Trump’s willingness to threaten them in the first place seemed to say something worrying about the unpredictability of US foreign policy. Trump’s threat to slap Germany with sanctions over the Nord Stream 2 didn’t help. That’s why Fed cut expectations remained “sticky” even after Trump “suspended” the Mexico duties.
Goldman addresses this in a new note that finds the bank attempting to break market pricing down into four “stylized scenarios”, as follows:
We call an expected funds rate above 2.5% a rate hike, a funds rate of 2.25%-2.5% no change to the policy rate, a funds rate of 1.5-2.25% (25-75bp of cuts) an insurance cut scenario, and a funds rate below 1.5% (100bp of cuts or more) a recession cut. These definitions are admittedly somewhat arbitrary and the two cut scenarios might overlap at times.
The bank then estimates the market-implied odds of each scenario. We’ll spare you the math on that, and just cut to the chase (get it?). Goldman notes that “the market-implied odds of moderate cuts rose sharply in the weeks following the December FOMC meeting but have held steady since then [while] the market-implied odds of large recession cuts over the next year have risen substantially since early May.”
Goldman goes on to “dig deeper” into why the bond market has recently assigned greater odds to “recession scenarios” over the course of the last six or so weeks.
In keeping with everything noted above, the main problem is the signaling effect from the Mexico tariff threat.
“In the case of trade war escalation against Mexico, the initial tariff threat boosted recession cut odds substantially, but the news that tariffs would be avoided led to only a partial reversal”, Goldman writes, adding that “this suggests the bond market has interpreted the recent tariff threats as signaling a persistent rise in trade war risk broadly and alongside it an increase in global recession risk.”
Again, the Mexico threat was the straw that broke the camel’s back, with a miss on the Markit PMI and the worst ADP report in nine years adding fuel to the fire.
For their part, Goldman thinks the market’s interpretation of the Mexico tariff broadside is overdone. “We do expect some further escalation, with a 10% tariff imposed on roughly $300bn of remaining US imports from China, but we do not expect auto tariffs or a broader escalation beyond China, and we see the White House’s decision to avoid tariffs on Mexico as indicating concern about the risks”, the bank says, in the same note.
So, that’s the good news. The bad news is, they might be wrong. And it wouldn’t be their fault if they are, because, as Trump put it last week, “nobody can quite figure it out”, when it comes to “what’s up here”….
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