May 13, 2019
Amid the back-and-forth of retaliatory trade tariffs between the U.S. and China are some important tells in price action that indicate the situation has moved beyond bluster and snark into a more protracted standoff with negative implications for global growth. Any inclination to think that this too will soon blow over, like previous disputes in the negotiating process, should be checked against the breakdown in commodity prices and treasury bond yields as well as macroeconomic risk benchmarks like the Australian dollar and the Chinese yuan. We warned about this possibility one month ago in What’s wrong with this picture. Both currencies are now perched on a cliff edge (see chart below.) As a proxy for the general global condition, the Aussie dollar’s plight is particularly concerning.
China and the U.S. appear squaring off for a harder fight. Trump clearly sees toughness on trade to be a winning issue for his 2020 election campaign. With an increasingly dovish Fed as his insurance policy against harm to the economy or equity markets, previous assumptions that the president had been bluffing a weak hand or was too eager to cut a deal with the Chinese are proving wrong.
Trump’s aggressive posture is backing Chinese leadership into a corner. One reason blamed for the collapse in talks late last week was China’s demand that the text of any agreement is “balanced,” reflecting respect for its sovereign “dignity.” (https://reut.rs/2JgYqZF ) Those are loaded terms that mean different things to different people. But the need for saving face in many cultures can’t be overstated and the insertion of feelings into the equation now makes any potential deal significantly more difficult to achieve. Investors are right to worry that this sharp-elbows approach on trade by the U.S. will also draw similar reactions when it comes time to negotiate with the Japanese or the Europeans.
Markets are on the edge of a paradigm shift. The FX, commodity, and bond sectors have been telling us for some time that the threat to global growth from disruptions in supply chains and to fixed investments due to changing terms on trade are more pervasive and may be longer lasting than many forecasts currently assume. Volatility is waking up as doubts emerge over central bankers’ ability to counter these headwinds with traditional monetary policy. It’s a massive red flag and a sign that risk may be underpriced. Despite that, the temptation to buy weakness in this ten-year-old equity bull market is both instinctive and strong. But if FX (especially AUD and/or CNH) starts to break lower from here, this time will almost certainly be different.