If Donald Trump was looking to stoke enough uncertainty to make Fed chair Jerome Powell think twice about the notion that a “mid-cycle adjustment” will be enough to offset the psychological drag from the ongoing trade conflict, the president likely succeeded on Thursday.
Trump’s abrupt announcement of new tariffs on the remainder of Chinese imports took markets by surprise, just when US equities were in the middle of staging an impressive rebound off Wednesday’s post-FOMC selloff.
To be sure, it was clear that Trump wasn’t happy with China, but the announcement of new duties was still enough to send stocks careening lower in afternoon trading on Thursday.
It’s worth noting that one of the local risks for equities has now seemingly been realized.
Although Nomura’s CTA model still has spot SPX and NDX well above levels that would trigger de-leveraging from trend followers, it looks like we may be through levels where dealers’ gamma profile flips. “The larger local risk is Dealer Gamma flipping —SPX and SPY combined Gamma vs Spot is lined-up at 2983 (2979 ex 8/2/19 expiry) — so an accelerated move lower from there will see Dealers ‘Short Gamma’ and forced to sell more delta the lower the market goes”, the bank’s Charlie McElligott wrote Thursday.
If the afternoon losses hold, Thursday would mark the first time since December that the S&P has fallen 1% or more in consecutive sessions and the largest one-day spike in the VIX since mid-May.
Markets may ultimately regain their composure once everyone realizes Trump’s latest escalation is likely an effort to compel Beijing to make concessions over the next several weeks.
It’s also possible investors will take comfort in the notion that the more perceived irrationality emanating from the White House, the more likely the Fed will be to step in. After all, it was the assumption that the Mexico tariff threat cemented the case for a July cut that ultimately catalyzed the rebound in equities off the May lows.
In that context, and with the July Fed meeting in mind, we’ll leave you with a few excerpts from a June note by Deutsche Bank’s Alexandar Kocic, which seem particularly germane right now.
At the moment, there are three main agents that define the backbone of the underlying configuration with distinct economic profiles and attributes: Fed (fully rational), markets (conditionally rational), and politics which, from the economic view, can be characterized as conditionally irrational.
In the absence of conviction about the existence of political circuit breakers, the market is coopting the Fed to complete the market and offset any rationality gaps and “finance” potential deficits of economic rationality. The dilemma that defines the current structural instability is the tension between the desire to co-opt monetary policy to complete the markets and the Fed’s resistance towards its exaptation –the effort to drag the Fed into the policy mix and change or augment its role to subsidize the markets subjected to the side-effects of politics. Effectively, the Fed is expected to finance a potential supply of short-term protection (e.g. a lower deductibility S&P put) with long dated (OTM) put on its credibility; this is a position of increasing liability for them and is logical to expect some kind of contestation.