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Counterweight to trade conflict

| August 2, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The announcement of new US tariffs on an additional $300 billion in Chinese imports put an exclamation point on the latest Fed ease. Weak global growth, trade uncertainty and low inflation had led to the Fed’s latest cut, and the tariffs announced the next day could have only strengthened the case. The Fed now finds itself in part caught between US trade policy and its own mandate, and that can’t be an easy place.

Since trade tensions between the US and China started accelerating in early May, US real rates and implied inflation have both dropped. Real 10-year rates have slipped nearly 40 bp and breakeven inflation by nearly 20 bp. The market apparently sees the growth and inflation risks from trade conflict. And so does the Fed.

Exhibit 1: Real rates, inflation expectations have dropped as trade tensions rise

Source: Bloomberg

It has seemed likely from the beginning that US-China trade conflict will drag on (A trade war of attrition, A recipe for steady volatility). Some analysts have speculated that the Fed’s own explanation of its latest cut prompted the tariff announcement the next day, but trade conflict was likely to continue with or without a cut. Each side can tally up the potential costs for each side in imports, exports, companies and places. What is less clear is the costs that each side is willing to bear. That encourages steady, low-level conflict, or a war of attrition. The latest US tariffs are only the latest volley.

For investors, who bear the market impact of trade policy, few if any have advantage in anticipating the next twist in the conflict. That is a political calculus likely held by a close circle in the US and China. Investors should only take risks they can understand and manage.

Fortunately, the Fed for now has partly stepped in as a counterweight to uncertainty in US trade policy. The Fed poses risks that most investors can understand and manage. The Fed should help keep financial conditions easer and volatility lower than they might be otherwise deep into next year

* * *

The view in rates

Interest rate volatility, at least reflected in the MOVE index, dropped after the July 31 FOMC and then jumped with the latest US tariff announcement. Prospects of US-China trade war should keep volatility elevated, but the Fed seems inclined to counter the possible worst effects. Convexity still should perform well deep into 2020.

Rates have dropped and the yield curve has flattened dramatically in the last few sessions. Rates on the front end of the curve are limited by a Fed unwilling to commit to aggressive easing, but rates in the long end continue to signal concern about growth and inflation. If trade tensions keep rising, rates in the long end could fall further and further flatten the curve.

 The view in spreads

Spreads still look biased to tighten despite some widening in recent sessions. Concern about growth works to push spreads wider, but the Fed seems inclined to counter risks to growth. Spread volatility may go up, but buy on widening.

The view in credit

As Stephen Stanley points out in this issue, the recent benchmark GDP revisions raised estimates of household income by $400 billion and made the household balance sheet look even stronger than before. Low interest rates have spurred mortgage refinancing, which should further reduce household debt burden. Low rates should also give some support to home prices, which should help homeowners continue building their equity. Of the major balance sheets in the economy—government, corporations, households and banking—households may be the strongest.

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