Trade tension may put a stubborn cap on rates

admin | 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. This material does not constitute research.

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.

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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.