Uncategorized

Trade tension may put a stubborn cap on rates

| December 6, 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.

US trade policy continues to put a cap on US rates. Markets have tended to see trade frictions as isolated and resolvable episodes, but again within the last week trade has pushed rates lower. Persistent friction increasingly looks like a core part of US strategy for managing foreign relations, and rates have become a side effect. It has helped drive Treasury rates below 2% this year and stands to keep rates biased below implied forwards until the market fully prices the risk premium.

The US has used tariffs or the threat of tariffs this year against Argentina, Brazil, China, the European Union, France, Japan and Mexico and reportedly considered tariffs against Australia and Turkey. The threatened tariffs against Mexico came as part of negotiations on immigration policy, so the US has shown a willingness to use tariffs for purposes other than economic policy. Last year the US imposed tariffs on imported steel and aluminum from all countries.

Beyond tariffs, the US has also generally shunned multilateral trade arrangements in favor of bilateral ones more vulnerable to volatile negotiations. In January 2017, the US withdrew from the Trans-Pacific Partnership that promised to establish trade rules between 11 countries including Australia, Canada, Japan and Mexico. In December 2018, the US announced plans to withdraw from the North American Free Trade Agreement and proposed replacing it with a better agreement. The replacement has since been negotiated by not yet approved by the US.

Relatively low US economic exposure to trade gives the US initial advantage in most bilateral tariff battles, and that may be the initial appeal of the strategy. The US can usually put tariffs on a much larger share of the other country’s GDP. If that’s all that mattered, then bilateral tariff battles would be short and sweet, at least for the US. But as the US-China tariff battle is showing, there’s more than just nominal GDP at stake. The competing sides may differ in their economic and political willingness to bear the costs of tariffs, and that can offset imbalances in affected GDP and draw out the fight.

Even though the US economy has relatively low exposure to trade, the joint impact of uncertainty, slower global growth and flight-to-quality add up to lower US rates. The Fed’s willingness to counter trade frictions by cutting rates contributes, too. Look for the US to keep the trade pot boiling in 2020, with 5-year and shorter rates especially surprising to the low side.

* * *

The view in rates

Rates continue to run well below the levels consistent with likely near-term US growth and inflation, but risks from trade and the impact of lower trade on global growth weigh on the market. Fundamentals look good, with broad consensus around 2% for the next few years. Current 10-year breakevens around 170 bp also look low, with potential for realized inflation to come in above that level. That should relieve concerns about recession and allow yields in the long end of the curve to rise. The curve should steepen more than forward rates imply.

The view in spreads

The recent round of tariff threats should remind investors that trade negotiations and volatility usually go together, and volatility is not a friend to spread investors. Also, for December, caution on the risk of limited liquidity. That can hurt spreads, too. Eventually stable growth around 2% should be Goldilocks for credit, and that is a likely outcome. Investment grade and high yield credit broadly should continue to tighten. The weakest part of the leveraged loan and CLO markets could widen, but that’s an idiosyncrasy of heavy issuance of weak loans into a market dominated by CLOs, which are ill-equipped to absorb the supply. MBS performance has improved lately and should continue to improve as heavy volumes of recede from October forward.

The view in credit

Even steady 2% growth will catch the most leveraged credits, and spreads in leverage loans reflect some of that concern. Leverage in investment grade corporate credit also has trended up this year, but an accommodative Fed has provided a buffer. As for the US consumer, low unemployment, high income and high aggregate household wealth leave consumer balance sheets in good shape. The readiness of the Fed, the ECB and other central banks to backstop growth makes broad recession unlikely. The weakest credits should feel a slowing economy, but without recession, the averages should remain good.

admin
john.killian@santander.us
1 (646) 776-7714

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2023 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.

The Library

Search Articles