China devalued the yuan 1.5% vs. the dollar on Monday, pushing it above 7.00/$ for the first time since 2008. This set off significant volatility across equity markets and sent the 10-year U.S. Treasury yield down as low as 1.7250%. In other words, markets are drawing a direct line from trade policy uncertainty to expectations of a weaker U.S. economy. The bottom line is that policy-driven market volatility can get much worse.
China devalued its currency to 7.0507 yuan vs. the dollar, down 1.5% from Friday’s close, down 5.1% from mid-April, and down 10.9% since April 2018. Remember that, unlike the euro or yen, the yuan is what is known as a “managed float” – it is priced daily relative to a basket of currencies and maintains an interday +/-2% band vs. the dollar.
Trade tension and retaliation
Monday’s currency move was an undisguised retaliation for President Trump’s announcement on Thursday of further tariffs. As trade negotiations have dragged on (and on), President Trump announced 10% tariffs on $300 billion of Chinese goods to start September 1. For all intents and purposes, this latest escalation would mean that all imports from China are subject to some type of tariff, including consumer goods, which had largely escaped tariffs up to now.
Markets have been badly rattled by this move, partly because this escalation pushes a near-term resolution further off the table. Indeed, after all this time, trade tensions seem worse than ever. The S&P 500 finished Monday down 2.98% and the Dow fell 767 points in the worst day for equities since January 4. The 10-year Treasury yield has plunged and ended Monday at 1.7250%, down about 33 bps over the last three trading sessions. Yield curve inversion is now back in full force, with the 3M-10Y spread at -27 bps. In other words, markets are drawing an even more direct line from this latest trade tension escalation to a weakening economy.
Last week’s rate cut is a distant memory
Today’s overarching pessimism has caused markets to forget Fed Chair Powell’s post-FOMC hawkish comments and aggressively price rate cuts back into the outlook. The probability of a rate cut at the September 18 meeting is now 100%, with 37% odds of a 50 bps rate cut.1 More than two rate cuts are now priced into the curve by year-end. Will the Fed deliver? The Fed wants to stabilize markets, but also knows better than anyone that there is little rate cuts can do to ease bilateral trade tensions. Fed policy uncertainty could amplify market volatility instead of quell it.
Impact on economy
Policy uncertainty is the clear and present danger. On Monday, the ISM Non-Manufacturing Index unexpectedly dropped to 53.7, the lowest level since August 2016. Both services and manufacturing sectors have endured a steep decline in sentiment over the past six months, although both measures are still on the expansion side of the boom/bust 50/50 threshold. Thank goodness for consumer confidence, which remains close to cycle highs – for now. The very real risk is that, as the year winds down, Wall Street woes and gloomy business confidence hit Main Street.
Tariffs could translate into inflation
Tariffs of this magnitude could spark inflation. We have the case study of a small basket of tariff-affected consumer goods put in place in February 2018. Since that time, the tariff-affected basket saw consumer prices rise 3.4% versus broader goods inflation of 0.0%. Inflation is not the top-line worry at present. Moreover, the Fed would rightly interpret inflation driven by tariffs as a tax and would be unlikely to respond with rate hikes. But the erosion of consumer purchasing power could develop into a real threat to the overall economic expansion.
Expect the dollar to be center stage in tweets, election rhetoric and headlines. Currency manipulation has been a buzz phrase for elections over the last 20 years, but clearly this time around it will be even more of a focus. We don’t expect the Fed to directly intervene into the exchange rate market, but the dollar is already being cited by the administration as yet another reason to cut U.S. rates, thereby making the dollar less attractive.
Impact on investors
Not to be a peacenik, but there are no winners in a trade war. Investors can only try to manage the volatility, which could get worse from here. Falling core yields will give Barclays Aggregate returns a hefty boost, but after the price appreciation, the income will be paltry, hindering total returns in the future.