Trade optimism finally crescendoed in a steep bond selloff, as the market got the closest thing yet to confirmation that tariffs will, in fact, be rolled back as part of the much ballyhooed “Phase One” trade agreement.
Although the mood was damped a bit by reports that “some” Trump advisors are less than thrilled with the prospect of letting China off the tariff hook, the message on Thursday was abundantly clear: If there’s an interim deal, it will be accompanied by the removal of some tariffs.
That will be a momentous event, as it will mark the first real deescalation since the trade war began. Sure, there have been “pauses” and a couple of ceasefires, but the actual lifting of tariffs is a big step in the right direction, even if nobody believes “Phase Two” and “Phase Three” will ever see the light of day.
The rout in Treasurys was fairly dramatic. We dove into the specifics in “3-Sigma Bond Rout Sees Yields Erase August Plunge, While Front-End Prices Out Trump’s Rate Cut Hopes“, but the bottom line is that with 10-year yields making a run at 2%, it’s make or break time for the narrative.
“Bearish views on rates seem to be predicated on a trade deal and a subsequent mini-cycle scenario for the US economy, the fourth of the current cycle”, BofA’s Bruno Braizinha writes, adding that “in this scenario, the expected trade deal unwinds the impact of two years of trade wars on the global economy, leading indicators bottom out near term as we enter a new mini-cycle” and the current cycle is extended by “roughly three years”.
(BofA)
The result: higher yields and a steeper curve in the medium term.
The other scenario is dubbed “the rabbit hole” by Braizinha. It’s defined by ongoing weakness in the global economy and a lingering sense of angst that refuses to go away, even if an interim trade deal is ultimately inked.
He cites several familiar risks that could continue to cast a pall over the outlook including doubts about whether any deal will succeed in rolling back “the damage created by two years of trade wars”, the possibility that the easing of tensions on one front leads to the opening of other fronts particularly in locales “that benefited from the dislocation of supply chains out of China”, how Brexit will affect the UK economy (and do note the BoE sounded less than sanguine on Thursday), jitters around the impeachment inquiry in D.C., the 2020 election, and “odd geopolitical risk which is generally hard to predict but may exacerbate opportunistically in the context of the US election cycle”.
In that “rabbit hole” scenario, Braizinha says “the Fed is likely to be forced into a conventional easing path by a recoupling of the US economy to the global slowdown”.
(BofA)
Going by “historical templates”, that likely means US policy will “convergence to the zero lower bound by early 2021”. (For those interested in more on the specifics about the “effectiveness reliant on steep UST curve” column in the table above, see “Why A Flat Curve Ties The Fed’s Hands And May Force ‘Outer Rim’ Easing Options“).
So, which is it going to be? “The yellow brick road” (as Braizinha calls the new mini-cycle scenario) or the “rabbit hole”?
Well, it’s hard to say. Thursday was clearly a “yellow brick road” day, but as we’ve seen time and again this year, trade optimism can morph into abject misery with a single tweet, leading to a veritable collapse in long-end yields.
For the time being, we’re sill in what BofA calls “no man’s land”.
“The arguments above suggest a 1.4-2.0% neutral ground for 10yT yields in terms of medium-term scenarios for rates”, Braizinha goes on to write, on the way to musing that while 10-year yields will likely break 2% on their way to 2.5% on “a truly meaningful trade deal”, they could also fall to 1.4% or below “if the trade deal fails to unwind two years of damage to the global economy and global data continue to deteriorate”.
The 10Y is already there,1.95%, and there won’t be a truly meaningful trade deal…