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Fog of (Trade) War

Jul 10, 2019
By Jeffrey Rosenberg

Bond market highlights

  • The post G-20 “trade truce” in Osaka reduced the immediate tail risks from trade but kept the longer term uncertainty in place that began following the breakdown on May 6th of trade negotiations between the U.S. and China. In the aftermath, the market realizes that substantial progress requires much more than an agreement on the amount of soybeans China purchases from the U.S. Trade uncertainty now represents the key macro (and as we will argue, micro) risks to the outlook.
  • Fundamentally, trade uncertainty remains primarily an issue for the business side of the economy, but some broader softening in data fuels concerns that a spillover into labor markets, confidence and consumption could be next. That alongside falling inflation led the Fed to validate market expectations to deliver on Fed cuts as soon as July’s meeting, as in Chair Jerome Powell’s words from the June FOMC press conference, “an ounce of prevention is worth a pound of cure.”
  • Making sense of stock markets making new highs while bond yields make new lows: it’s a high-quality stock rotation fueling those new highs, consistent with past rate and spread behavior. That reflects the heightened micro economic consequences of trade conflict that macro policy can do little to remediate. A silver lining for investors however is such policies increase dispersion of returns, a benefit to alternative investment strategies like market neutral long/short investing.

The failure of China and U.S. negotiators to deliver the expected trade deal and the ratcheting up of trade frictions through the imposition of tariffs on May 6th marked a significant inflection point in the investment outlook. Though the G-20 “truce” delivered the market expected reduction in immediate risks, the threatened use of tariffs to address the immigration issue on the Mexican border had further inflamed investor anxieties over the administration’s willingness to use tariffs to address non-trade related foreign policy issues. And while the immigration issue eased through the effective engagement by Mexico (as well as the potential push back from Congressional Republicans), the truce in China trade talks resets the market’s expectations of a deal to a protracted debate with no clear signs of quick resolution.

Earlier in the year, expectations of a trade deal were incorrectly based on the notion that a superficial “deal” on trade would be agreed upon, leaving more substantial issues of forced technology transfer, intellectual property theft and fundamental disagreements over the role of state sponsorship in the economy off the table. With those elements forcibly placed back on the table and with the Chinese side incapable of compromising on these issues of substance, the market expectations for a deal have rapidly devolved to the best-case scenario of simply avoiding further deterioration and extending the negotiations potentially to a time past the 2020 elections. With no deadlines announced after the G-20 meeting, this appears to be the preferred route for both sides.

Seeing through the fog

Fed Chair Powell best summed up the situation as “We do not know how or when these issues will be resolved” June 4th at the Chicago Fed symposium, in comments that previewed the Fed’s pivot toward cutting rates, albeit in the June FOMC press conference Q&A with the caveat that “we would like to see whether these risks continue to weigh on the outlook.” Market expectations of significant cuts in Fed policy rates this year reflect expectations that despite any near-term movement in trade negotiations, the accumulation of risks will continue to weigh negatively. The near-term debate is over the timing and magnitude of easing, not whether an easing occurs.

Such cuts reflect the need for quick reaction of post-crisis monetary policy that stands closer to the zero (or effective) lower bound on cutting interest rates. In a post-crisis world, the main mechanism for policy transmission into the real economy is through the so called “portfolio balance” channel. Effectively, financial conditions – the broad array of financial prices – impacts economic activity through its impact on confidence, and through confidence's effects on consumption, hiring and investment.

Trade uncertainty grows into a weakening global growth outlook

Trade uncertainty grows into a weakening global growth outlook

Source: J.P Morgan. Haver Analytics, as of June 2019.

Today, the Fed’s ability to become more “accommodative” lies less in the textbook transmission of more favorable borrowing costs but rather through the impact on confidence. Hence, financial markets increase their expectations for Fed policy cuts to offset any tightening in financial conditions arising from trade uncertainties.

Weakening growth outlook prompts market expectations for the Fed to ease

Weakening growth outlook prompts market expectations for the Fed to ease

Source: Bloomberg data, as of June 2019.

Taken together, the expectations for the Fed to cut as early as July reflect a less “data dependent” view of the Fed. The data has held up relatively well and most forecasts for growth indicate steady, albeit deceleration in U.S. growth to a 2-2.5% pace – the very long-term or “sustainable” pace of growth projected by the Fed.

Rather the need to cut reflects the “sustain the expansion” refrain now opening the Chair Jerome Powell’s public pronouncements. Hence, conditional on the cut in rates, the expansion can be sustained, and presumably the forecasts for growth can hold up.

Inflation downturn also supports expectations for Fed cuts

And while the trade narrative hijacked the recent past focus on inflation, there too the market finds some justification for the Fed’s “insurance” cuts. Recent declines in some measures of inflation reflect falling growth prospects (e.g. declines in TIPS “breakeven” measures) while persistent undershooting of realized inflation appears to be impacting longer-run forecasts of inflation. In fact, a long-term measure of inflation, the University of Michigan 5yr-10yr inflation expectations fell to historical lows in June to 2.2%.

Inflation collapse may also be fueling expectations for Fed “insurance” cuts

Inflation collapse may also be fueling expectations for Fed “insurance” cuts

Source: Bloomberg and University of Michigan, as of June 2019.

The latter is especially concerning to the Fed as anchoring longer run expectations for inflation is a key goal to avoiding longer run deflationary outcomes. From this vantage point, the market may also reflect expectations for the Fed cuts as “insurance” less about growth impacts stemming from the trade impasse and more from concerns over loss of inflation credibility (in this case from achieving too little inflation).

Stop making sense?

For equity and fixed income investors, how do we make sense of stock markets making new highs while bond yields make new lows?

Find out more in our latest systematic fixed income commentary.

Read more 

Jeffrey Rosenberg
Sr. Portfolio Manager, Systematic Fixed Income
Jeffrey Rosenberg, CFA, Managing Director, leads active and factor investments for mutual funds, institutional portfolios and ETFs within BlackRock's Systematic Fixed ...