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Tariffs Are Here

May 19, 2019

Given the sharp drop in rates last week, we blessed our readers with a mid-week newsletter about whether it made sense to lock in fixed rates that were below floating. Therefore, you get an abbreviated newsletter this week to quickly cover the possible rate outcomes based on the trade tensions between the US and China. 

Last Week This Morning

  • 10 Year Treasury pushed lower on negative news on China trade deal, closing the week at 2.39%
    • German bund at -0.10%
    • Japan 10yr at -0.07%
  • 2 Year Treasury closed at 2.20%
  • LIBOR at 2.43% and SOFR at 2.43%
  • China retaliated…buckle up
  • I’m probably very bummed about the GoT series finale last night

Tariffs Are Here

The odds of a quick resolution with China dropped considerably last week, leading to a sharp drop in rates.  For now, Trump seems to have bipartisan support, while Chinese PM Xi likely wants to show strength in response.  This is starting to look like it could drag on another year plus and maybe the best the market can hope for right now is avoiding further escalation.

 

Base Case Scenario – Holding Pattern (60%)

Both countries move forward with tariffs but hold off on escalating the situation.  A deal is not reached until sometime in 2020, perhaps with the election ratcheting up pressure on Trump.

One big caveat here is that Trump and Xi may pursue one on one talks, with the next real opportunity coming at the G20 meeting in June.  Trump has hosted Xi at Mar a Lago, so the market has to price in the possibility of a surprise agreement.  Each Trump tweet probably causes that much more volatility.

Both countries lose, but China loses more.  Consensus economic forecasts call for a drag on US GDP this year of about 0.1%, nothing earth shattering.  Inflation probably ticks up ever so slightly, maybe around 0.2%.

China’s central bank will increase accommodation, while Trump will keep pressuring the Fed to cut rates.  Powell won’t cut rates because Trump says so, but he may very well end up cutting rates anyway if the data softens or if the market panics.

It’s difficult to envision a scenario where the 10 Year Treasury moves up to 3.0%, while 2.0% can’t be written off.

 

Let’s Make a Deal (25%)

This would be much lower if not for the fact that Trump could very well reach a handshake deal with Xi behind the scenes.  China backpedaled on a several agreed-upon points, which calls into question whether they are negotiating in good faith.   Additionally, both leaders and both countries will be extremely sensitive to losing face at this point.

But if a deal was reached, the event risk from a trade war could be taken off the table and encourage some risk taking.  But even then, I don’t see a 3% 10 Year Treasury.  Instead, we might see a pop back up to 2.62%.

An agreement would also likely eliminate the need for any rate cuts through the end of 2020.

 

Escalation (15%)

There’s very little reason for either side to escalate at the point.  And in the US it would take some time to actually implement because the US Trade Representative’s proposal would necessitate a window for public comment.

But if this did happen, we can expect the Fed to cut rates 0.50% – 0.75% and the 10 Year Treasury to push below 2.00%.

This Week

Trade war news is all that matters right now, but Powell speaks Monday about risks to the financial system…good timing.  Wednesday’s FOMC minutes from the last meeting probably won’t reveal anything new, but the market will be hoping for a Fed willing to adapt to deteriorating conditions.