The straw that broke the camel's back?

This article was written by Richard Horswill. All views and opinions expressed are strictly his own.

Tariffs, and with them potential trade wars as China and the EU push back, ignited a two trillion dollar stock market rout, commodity dump and a safe haven rush into US government debt after the Trump administration made it clear ten days ago that they were not going to accept continual trade deficits without compensation. Tariffs are yet another shock to the global economy following pandemic, war, geopolitical upheaval, and an energy supply shock which have all contributed to the sense of a globally synchronised economic malaise for the last few years. Until the pandemic kicked off the synchronisation process, the global economy had already been in a funk following the 2008 crisis, held in a low growth cycle and only able to manage anaemic growth with interest rates at zero. This new assault on the global economy has been initially seen as inflationary, and with global growth expectations sliding precipitously, a stagflationary recession is looking highly likely. 

Stagflation, however - a combination of rising prices and slow economic growth - is unlikely to persist. Whilst many commentators point to the 1970s expecting similar outcomes, that period experienced massive increases in money supply as commercial banks expanded their balance sheets as investment flourished. Wages also rose during that period keeping up with the inflation as economic growth was high, albeit with high unemployment. Thus despite the economic turbulence, UK GDP during the 1970’s averaged an annual rate of 2.7% with the US running at 3.5%. Today, GDP growth in the UK is effectively zero, with the US likely to lose its growth lever as DOGE is committed to cut one trillion dollars from government spending through efficiencies. If this financial hole isn’t filled by the private sector, US GDP will flatline. Thus, it would seem that we are in a different place today from the period described as commercial bank lending is currently tepid, and government spending levers have been withheld due to the current central bank mantra of higher for longer, meaning debt servicing remains on a seemingly unsustainable path unless rates come down sharply. Hence, the sentiment that stagflation will not last long, as the growth mechanisms are both out of action which will almost certainly lead to economic contraction and demand destruction as the consumer will be out of money and out of luck as the squeeze from the rising prices and central banker belligerence contracts disposable incomes and discretionary spending. Not a pretty picture, and one where inflation is certainly not going to be a problem for long!

Interestingly, as the financial markets buckled, forward US interest rates were falling sharply as the markets recognised that future growth and money supply expectations were limited, seeing the 2 year yield falling sharply to 3.5% until the chairman of the Federal Reserve, Jerome Powell stated that a wait and see policy from the central bank was appropriate. The markets have been on a completely different path from the monetary authorities for the last couple of years as inverted yield curves led the way in market thinking, but particularly now as global trade is highly likely to take another leg down due to tariffs, and without any market support the rout looks set to continue for a while to come unless the Donald does some back tracking which seems unlikely. It would seem that the only release valve for the global economy currently would be a return to a low interest rate environment, with markets clearly pricing in rate reductions. How long it will take for the central bankers, in particular of the US and UK who seem to be the most controversially hawkish, to act remains to be seen. That said, if the market rout continues, don’t be surprised if emergency cuts attempt to come to the rescue. Of course, monetary policy lags prevail, so even if they relent and cut, any effects will be limited in the short term. 

Could this be a crisis moment, or will common sense prevail with leaders attempting to negotiate will cool and calm heads? The broad nature of the sell off may just suggest that this crisis may have legs. China in particular has most to lose as the manufacturing engine of the world. They have little room to manoeuvre due to the size of the trade deficit unless they attempt to devalue their currency to mitigate some of the tariff cost. This of course could heighten the current distrust as manipulating the Yuan would be seen as yet another attack on the Trump policy. Whilst the one off price increases have an inflationary feel, they will ultimately act in the opposite way, taking the global economy into a potential slump or even a depression. If this comes to pass, expect the gold rally to resume and interest rates to head back to zero as safety and liquidity will be the order of the day with government debt the ultimate safe haven trade. Also, as global trade contracts we can expect the dollar to move higher against all other currencies as dollar shortages create the pathway for the strong dollar. This will keep the global economy on the back foot for many years to come particularly while the enacted Trump policies remain in place. On a positive note - well, I’m still struggling to find one.

Addendum

The above was written on 5th April, while Lord Copper was on holiday, and between then and publication now, there have been further developments and significant volatility in markets, so it seems appropriate to address the particular reasons that may have led to the hiatus and thus limitations in Trump tariff policy ex-China.

The basis of the original article remains the base case; however, there is a need to address the short term spike in treasury yields that seemingly made the Trump treasury team blink.

The safety trade, the purchase of treasury bonds and bills after the massive sell off in US stock markets saw the 2 year yield hitting about 3.5% and the 10 year at a low of about 3.9% as investor sought the safe haven of US government debt. However, last week saw something of a temporary reversal in this trade. 

The basic explanation revolves around the liquidity in global funding, particularly in international trade as tariffs will certainly curb the amount of funding required and hence dollar supply. Thus, due to the volatility set in train by the tariffs, dollar funding and therefore shortages resulted as global banks tightened their lending practices which immediately led to large sales of treasury holdings from foreign reserve managers. (Possibly central banks) This put pressure on intermediary dealer balance sheets, needing to sell into the repo market raising price volatility, margins on treasury futures and thus increasing uncertainty on repo rates and liquidity in the market. As this market move occurred, hedge funds engaged in something called the “basis trade” were forced out of this seemingly innocuous trade. Hedge funds use significant leverage to go long treasury bonds in repo, whilst selling the offsetting futures contract to make a few basis points, hence the name of the trade. As such, these hedge funds were forced out of their basis positions having to sell the cash treasuries in repo whilst purchasing their offsetting short futures contracts creating a double whammy unwind and subsequent liquidity issue in the repo market. This counter-intuitive move in treasury yields, subsequent to the initial safety trade the previous week, seemingly led to the decision to row back on the tariff policy temporarily. That said, this move should only be seen as temporary and should not be seen as a confidence blow to the US dollar reserve status. However, should volatility in these markets remain heightened, the banking sector may require Central Bank balance sheet intervention as commercial banks struggle with potential balance sheet capacity due to the increasing volatility. Much has been said about the Federal Reserve in particular not intervening by reducing borrowing costs for fear of upsetting their inflation mandate! This may be rowed back on in due course as global recession fears are paramount and will likely lead to the inflation mandate taking a back seat. Time and volatility will tell.