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.