Trade Wars Escalate

The big news everyone will wake up to is the latest escalation in the trade wars between the U.S. and China. The situation is obviously a clear net negative for the economy that will keep the Fed biased toward easing again in September. The Fed will remain under pressure to help President Trump fight his trade wars with lower interest rates in the months ahead.

Last week, Trump surprised market participants by announcing that 10% tariffs on another $300 billion of Chinese goods would go into effect on September 1. Tonight, China retaliated via two channels. First, the yuan fell broke through the 7 to a dollar barrier, trading down to 7.0256 at the moment. Importantly, the move was tied directly to the tariff threat. Second, China has asked (told?) state-owned operations to cease buying U.S. agricultural products.

The first move was obviously aimed at offsetting the costs of the proposed tariffs; the second move targets in particular the political base that supports Trump. The latter will be a particular blow to Trump given that the lack of commitment on agricultural purchases is reportedly what triggered Trump tariff’s threat in the first place. Via the Wall Street Journal:

Mr. Trump, who had a re-election rally scheduled in Ohio later that day, wanted to be able to assure farmers—who have been hardest hit by the trade fight as China scaled back purchases of U.S. corn, soybeans and pork—that he had at least secured concrete commitments from the Chinese that they would boost their purchases of U.S. agricultural exports.

But to his frustration, Messrs. Lighthizer and Mnuchin couldn’t give him any guarantees.

Tump got a commitment on agricultural purchases after all, although pretty much the opposite of what he was looking for.

I can only imagine that Federal Reserve Chairman Jerome Powell and his colleagues are quietly seething about the escalation of the trade wars. To be sure, at last week’s presser Powell was careful to not offer direct criticism of Trump’s trade policy:

…I want to be clear here. We play no role whatsoever in assessing or evaluating trade policies other than as trade policy uncertainty has an effect on the U.S. economy in the short and medium term. We’re not in any way criticizing trade policy. That’s really not our job.

Realistically though the Fed must be frustrated. They thought they had the economy pretty much dialed in and then Trump runs around like the proverbial “bull in the [C]hina shop” and threatens to screw the whole thing up. Worse, it is hard to not see that one reason Trump thinks he can make this play is that he believes the Fed, albeit reluctantly, has his back. To be sure, Powell did not say trade uncertainty was the only factor that drove the rate cut, but it seemed clear that it was the central factor. Recall also that the Fed’s pivot toward easing came suddenly after the threat of tariffs on Mexico.

Couple of things here. First, the Fed is doing the right thing by easing in response to the tariff-related uncertainty. It is their job to offset shocks to the U.S. economy. Second, I think that if Trump believes the Fed will be able to bail him out entirely, he is likely badly mistaken.

Think of it this way: At a very basic level, tariffs will create a fresh set of winners and losers in the economy but at least via direct channels have a fairly small direct effect at the macro level. Back to Powell:

You know, the mechanical effects of the tariffs are quite small. They’re not large as it relates to the U.S. economy. The real question is what are the effects on the economy through the confidence channel, business confidence channel. And again, very, very hard to tease that out. I’ve seen some research, which, you know, which says that they are meaningful, meaningful effects on output as to say not trivial. And I think that that sounds right, but it’s quite hard to get—there is no way to get an accurate measure…

Assume that the Fed can largely offset the tariff and confidence effects on the macro economy via easier policy. This, however, will not necessarily reverse the relative impact on winners and losers. In particular, a significant contingent of the losers of the trade wars are in Trump’s agricultural base. I doubt the Fed easing would do much to directly offset that loses that they are about to suffer. Hence, I think the Fed’s power to bail out Trump may be somewhat limited. His base will still get hurt.

At the press conference, Powell also laid out the script that financial market participants are already following. As I write, yields on the 2- and 10- year treasury bonds are both down 7 basis points to 1.64 and 1.78, respectively, and odds of a 50bp point cut at the next meeting have jumped to roughly 30%. The Fed will be in a difficult position this week. If Fed speakers emphasize the trade risks, they will reinforce expectations for that 50bp cut. But they can’t really avoid the trade risks, or downplay them in this market, so I am not sure they can avoid that outcome. Only an easing of trade tensions can help them at the moment.

Bottom Line: Continued trade uncertainty means the baseline scenario is that the Fed eases again in September.