Round 3 of the tariff wars

The stock market hit an air pocket today, buffeted late last week by news that Trump had threatened to unleash a new round of tariffs on Chinese imports, and news today that the Chinese yuan had fallen below 7 to the dollar. For good measure, the Chinese government also announced it would retaliate by restricting imports of US agricultural products.

Yikes, thought the market, maybe this is going to turn into a full-fledged tariff war after all! Better sell now before the sh*t hits the fan!

I've mentioned before that if Trump's tariffs are going to have their intended effect, namely forcing China to lower its trade barriers and respect intellectual property rights, then the Chinese are going to have to be very worried that bad things are going to happen to their economy if they don't make a deal with Trump. It's also true that for the Chinese to take Trump seriously, just about everyone needs to be worried that Trump is out of control and the global economy is headed for a fall. If we aren't scared, the Chinese never will be.

Well, it's looking like we're getting closer to that point.

Chart #1

Chart #1 compares the level of China's forex reserves to the value of the yuan vis a vis the dollar. What this says is that the huge rise in the yuan's value leading up to 2014 was largely due to a huge influx of capital. The Bank of China was actively trying to suppress the yuan's value, since if it hadn't bought more dollars and sold more yuan, the yuan would have risen even further. But from mid-2014 to mid-2017, capital began to flee China. This forced the Bank of China to sell its forex reserves and buy yuan, otherwise the yuan would have depreciated even more against the dollar. Until recently, it seems that the Bank of China has been targeting a fixed level of reserves, and allowing the yuan to fluctuate with the winds of capital flows. The recent drop in the yuan virtually guarantees that capital is desperate to abandon China. At the same time, China's economy has been slowing. China is far more dependent on trade with the US than the US is with China. Trade disruptions are disrupting China's economy meaningfully, and that is putting increasing pressure on Chinas' leadership to make a deal. Further declines in the yuan's value will put tremendous pressure on China to make a deal, otherwise their economy could be crippled.

Chart #2

Chart #2 shows that the market's level of fear, uncertainty and doubt (as proxied by the ratio of the Vix Index to the 10-yr Treasury yield) is today as high as it has been in many years. We are in Panic Territory. Yet I note that the selloff in stocks has not been very deep so far. This could mean that the market is not really terrified, because the market realizes that although things look really bad today, they can be fixed with a simple Trump tweet or a Chinese capitulation. In any event, it's worth noting that FUD is high but stocks have not really suffered very much. But does that imply the market is over-confident? Not necessarily.

Chart #3

Chart #3 shows that the real yield curve today has inverted even more. The market is expecting the Fed to be forced into deep cuts, since otherwise an escalating trade war with China could cause serious damage to the Chinese economy, and that would inevitably be felt here at home as well. In any event, the market is sending a strong signal to the Fed that monetary conditions are too tight right now. That in turn is due to a sharp rise in risk aversion and a sharp increase in the demand for money and other safe havens, both of which have not been alleviated by offsetting Fed actions (e.g., lower rates, which have the effect of making cash and money less attractive).

Chart #4

Chart #4 shows the implied rate on Fed funds futures contracts that mature next June. The market fully expects the funds rate at that time to trade at around 1.6%, which would further imply three more 25 bps cuts to the current funds rate of 2.25%. That in turn means the market thinks the economy is going to be sucking pondwater pretty soon.

Correction: (9;28 pm PST) I need better reading glasses. This chart says that the market expects the funds rate to be 1.2% by next summer, not 1.6%. That implies four more 25 bps cuts to the current funds rate. HT: Mike Churchill

Chart #5

Chart #5 compares the price of gold to the price of 5-yr TIPS (proxied here by the inverse of their real yield). Both tend to rise in periods of uncertainty. Moreover, the recent rise could be attributed to the market thinking that the Fed has fallen so far "behind the curve" that in the end it will be forced to ease too much, and that will ignite an unwelcome rise in future inflation (gold and TIPS both promise protection from rising inflation). The market is getting pretty worried about the future, it's safe to say.

Chart #6

Chart #6 shows the spread between 10- and 30-yr Treasury bond yields. The long end of the Treasury curve has been steepening, even as the front end has been inverting. This reinforces the view that eventually the Fed is going to be forced to "reflate," and that would be bad for long-dated bond prices.

Chart #7

Chart #7 shows the yield on 10-yr Treasury bonds. Late last year it looked like bond yields had broken out of their long-term downtrend. Now it looks like that downtrend is still intact. I'm not a technical chart devotee, but there are a lot them out there, and this chart has gotten their attention, you can be sure. That US yields have fallen this low implies 1) great demand for equity hedges (which in turn implies a lot of bearish sentiment), 2 very low inflation expectations, and/or 3) a belief that the Fed is at risk of making a deflationary mistake.

Chart #8

Yet despite all the doom and gloom priced into the Treasury market, Chart #8 shows that the corporate market is only a tiny bit concerned about the outlook for corporate profits. Spreads on generic 5-yr Credit Default Swaps have only risen modestly from very low levels. Similarly, I note that swap spreads are extremely low (2-yr swap spreads have fallen to -7 bps), both here and in the Eurozone. This suggests both a dearth of safe-haven assets, and strong liquidity conditions. Investors are buying swap spreads instead of other high-quality bonds because they are trying to hedge their exposure to stocks and other risk assets—not because they are afraid the economy will collapse. As I argued in my last post, the low level of real yields and the abundance of bank reserves imply that financial conditions in the US are not deteriorating; money is not hard to come by, and therefore the economy is not at great risk of a Fed mistake.

This further suggests that the carnage being priced into assets today is still in the minds of investors, and is not yet to be found in the physical world.

Chart #9

With the rush to safe-haven assets, the PE ratio on the S&P 500 has fallen to 18.6, which gives the stock market an earnings yield of 5.4%, which is a whopping 370 bps above the yield on 10-yr Treasuries (see Chart #9). You have to go back to the scary days of the late 1970s to find an equity risk premium that high. One thing this chart says for sure: the market is quite pessimistic about the risks that the future holds.

If Trump and China figure out how to make a face-saving deal, the upside potential out there could be very impressive indeed.

A non-fatal Fed mistake

Yesterday the FOMC decided to reduce its short-term interest rate target by 25 bps. It was a move in the right direction (as I suggested in late May), but as today's market action demonstrated, it was an overly cautious move, particularly in light of escalating global trade tensions (i.e., Trump's tariffs, which today he threatened to ratchet higher). The US economy, as well as most major global economies, are facing headwinds, uncertainties, and slower growth, all of which have increased risk-aversion and the demand for money equivalents. A 25 bps cut to short-term interest rates helps offset the world's increased demand for money (by making money and money-equivalents less attractive), but only partially.

A bigger cut would have been better, but this was not a fatal mistake. Why? Because the level of real interest rates remains relatively low, and liquidity conditions—thanks to the still-abundant supply of excess bank reserves and the low level of 2-yr swap spreads—are still quite healthy. The market is likely to be on edge for awhile, but there is still time for the Fed to correct this mistake and/or for trade tensions to dissipate and risk-aversion to recede.

Chart #1

Chart #2

Chart #1 shows 5-yr real and nominal interest rates, and the difference between the two (green line), which is the market's expectation for what the CPI will average over the next 5 years. Interest rates have declined significantly so far this year, but inflation expectations have only subsided slightly. That's because the most important decline in interest rates has been in real yields, which are a proxy for the market's expectation for future economic growth rates, as Chart #2 suggests. Real yields are down because the market is losing confidence in future economic growth prospects. Inflation expectations have also subsided somewhat, which further suggests that the market thinks monetary policy is a bit too tight.

Chart #3

Chart #3 compares the real yield on 5-yr TIPS (the best measure of market-based real yields that is readily available) with the real Fed funds rate (which is the current Fed target rate minus the rate of core PCE inflation over the past year). Bond market math dictates that the red line is what the market expects the blue line to average over the next 5 years. The market is expecting further Fed rate cuts—about 2-3 more at the present time—over the next year. This is the market's way of telegraphing to the Fed that monetary policy is too tight and that lower interest rates are needed. Note also that the blue line marks the very front end off the real yield curve, while the red line marks the intermediate area of the real yield curve. When the blue line exceeds the red line, the real yield curve is inverted (as it is now), and that is a good indication that the economy is likely to slow down. Inverted yield curves are almost always a sign of slower growth to come.

Chart #4

But the shape of the yield curve is not the whole story. The other important part of the story is the level of real yields, which is shown by the blue line in Chart #4. In the past, every recession has been preceded by high real yields and a flat or inverted yield curve. Today we have only one of those indicators: the shape of the yield curve, which is slightly inverted. Real yields remain historically low. thus, a recession is far from inevitable.

Chart #5

Prior to the Great Recession, the Fed had only one way to tighten monetary policy, and that was to reduce (or increase) the supply of bank reserves. That typically resulted in higher (or lower) short-term interest rates. Today, the Fed doesn't need to increase the supply of bank reserves in order to force short-term interest rates lower. It simply declares that it will pay a lower rate of interest on excess bank reserves, which, as Chart #5 shows, are abundant—to the tune of almost $1.5 trillion.

Chart #6

With bank reserves still abundant, swap spreads are still very low, as Chart #6 shows. This means that liquidity conditions in the financial market are very healthy. Nobody is being starved for money. Money in fact is now easier to get thanks to lower interest rates. This is a very important difference compared to prior episodes of monetary tightening or easing. Things are VERY different this time around.

It's a mistake to think that although it appears that today's monetary conditions are a bit tight (e.g, inverted yield curve, lower prices for risky assets), the economy is at risk. The Fed doesn't need to reduce interest rates in order to "bail out" the economy or to give it a shot of stimulus. The purpose of adjusting short-term interest rates lower under the current monetary regime of abundant excess reserves is not to "stimulate" the economy but rather to keep the supply of money in line with the demand for money. That, in turn, will keep financial markets healthy, avoid asset price bubbles and keep inflation low and relatively stable. Remember, monetary policy was never meant to stimulate or throttle growth. Growth is not created magically when the Fed lowers interest rates. Monetary policy is meant to keep the supply and demand for money in balance, and thus to deliver low and stable inflation, which in turn is conducive to growth.

The Powell Fed was too cautious in its decision yesterday, but it was not a fatal mistake.

Consumer confidence is soaring

If you happen to watch the Democratic debates tonight and tomorrow, think about this: consumer confidence these days is approaching record high levels, and the impetus to the current surge in confidence can be traced to Trump's election in late 2016. Challengers to Trump are going to have a tough time convincing voters that change is needed.

The charts that follow show three of the most widely-followed indices that track consumer confidence. All data is as of July 2019. Chart #1 is the Conference Board's index of Consumer Confidence. Chart #2 comes from the University of Michigan. Chart #3 comes from Bloomberg.

Chart #1

Chart #2

Chart #3