Donald Trump’s gamble weaves monetary policy into trade war
Markets and central banks have a long and entertaining history of second guessing each other. Complicating this relationship today is a very squeaky third wheel in the form of Donald Trump, US president, and his penchant for playing the role of Tariff Man.
The investment backdrop has been dominated for some time by a test of wills between markets and central banks as to the scale of damage ultimately inflicted upon the global economy by a rising tide of trade protectionism.
In the US, Japan, Germany and the UK, two- and 10-year government bond yields all currently trade below the official overnight rates set by their respective central banks, a trend exacerbated after Mr Trump announced plans to slap a 10 per cent tariff on the remaining $300bn of Chinese goods that have escaped such a levy, including clothes, toys and smartphones. This is the markets’ way of telling policymakers, “more please”.
Until this latest trade salvo, the heads of the European Central Bank, Bank of Japan and the US Federal Reserve had revealed an understandable reluctance to fully endorse the global sovereign bond market message that a new wave of significant monetary easing beckons.
In the case of the BoJ and ECB, both institutions have limited room to ease further, and much of their respective bond markets already sit deep in negative-yielding territory.
The underlying tone is that any new stimulus is designed to extend the current cycle, rather than prevent an imminent global recession, which is the picture being sketched by this year’s appreciable slide in short- and long-term bond yields.
Central bank prudence was highlighted earlier this week when Jay Powell of the Fed described the bank’s first quarter percentage-point reduction in overnight borrowing costs for more than a decade, as a “mid-cycle adjustment to policy’’, a remark that trimmed the bond market’s sails and unsettled equities.
As for trade, Mr Powell made a couple of interesting points: “The thing is, there isn’t a lot of experience in responding to global trade tensions. So it is something that we haven’t faced before and that we are learning by doing.”
Less than 24 hours after Mr Powell had noted that trade tensions were simmering — after nearly boiling over in May and June — the trade temperature was dialled up yet again. Notably, European carmakers are clearly in the US president’s sights. One can see the method behind Mr Trump’s escalation over trade with China.
It is popular with an election year dawning, especially in the swing states he needs to win, while there is also an assumption that any blowback for the US economy from higher tariffs can be allayed by aggressive Fed easing.
This greatly complicates the picture for investors. What is apparent from the short history of trade protectionism during the course of the Trump administration is that equities take a hit for several weeks, before selling pressure abates. There have been three major equity corrections: early 2018, the autumn of 2018 and May of 2019, all triggered by the US escalating tariffs on Chinese goods.
There is also a chance that Mr Trump’s high-stakes poker does result in a deal between China and the US, so investors may well have a very good buying opportunity in equities, while the bond market runs the risk of a shakeout.
However, bouts of financial market volatility do leave scars, and tolerating a weakening renminbi is also a card that China may well finally play in the coming weeks. Ultimately, investors must also gauge just how damaging trade becomes and whether Mr Trump’s faith in lower interest rates to help sustain the domestic economy — and of course equity prices — is justified.
Interest rates represent a blunt weapon for addressing a fundamental recasting of trade relations and frankly will do little to arrest a significant hit to global business investment. Eventually, this registers with consumers and a still-resilient service sector.
Investors recognise this risk, as much of this year’s rally in equities has been powered by the sharp decline in bond yields. A preference for companies that are defensive in nature and dubbed “bond proxies” is growing rapidly.
These are attractive qualities when broad economic growth is slowing and profit margins are being squeezed, as seen via the latest tide of earnings from US and European companies.
Mr Powell’s reluctance to signal an extended easing cycle on Wednesday reflected in part a desire to preserve monetary ammunition until it is really required, thereby delivering a timely rap across the market’s knuckles.
Now, as monetary policy becomes a tool for trade negotiations, the likelihood is one of far lower bond yields that can only support high valuations for equities and credit up to a point. Ending the trade war, rather than relying on lower rates is the ideal solution.