Trade War Complacency

The escalating rounds of tariffs between the United States and China is an interesting point of economic debate. However, from the perspective of the interest rate markets, it appears to be one of those subjects that generates a great deal of economist commentary, but with limited market impact. This view is arguably complacent; whether it is too complacent is left for the reader to judge.

Things Could Go Horribly Wrong

It is entirely possible that escalation could continue, aided by the anti-moderation impulses of President Trump. If global supply chains were cut as a result of trade barriers, firms would need to scramble to rebuild them domestically. Countries would very rapidly hit capacity barriers, since they would have to ramp up industrial investment that has withered over the past decades.

This is easily one of the structural changes that could change the trend in inflation. Imported goods would no longer act as a deflationary undertow. As a result, this is an outcome that needs to be taken seriously.

China Dumping Treasurys -- Yeah, Whatever

The one risk that seems to captivate many Treasury bears is the possibility that China will dump its Treasury holdings, causing yields to soar. In my view, this is just sour grapes by commentators who were wildly wrong about Treasury yields in the past. They want to blame Chinese Treasury purchases for being wrong then, and so they want to believe that they will be vindicated by history.

The proper way to frame this risk as follows: if the Chinese wish, they could lose a lot of money selling Treasury securities rapidly. This would also cause the CNY to spike, doubling down on the pain for their exporters. (They would have little choice but to buy their own currency; if they attempted to destabilise the Treasury market, no other developed country would welcome the reserve inflows.)

The only reason that this would not be an utterly idiotic move on their part is that they feared expropriation of their reserves. Things would have to get extremely ugly on the geopolitical front for that to be a plausible risk. Such a move by the United States could destroy the entire USD-based global trading system.

In any event, the interest rate spike would be short-lived. As the Federal Reserve proved with its Quantitative Easing programme, it could wade into the market and buy up any amount of Treasury bonds if it felt that high yields were destabilising the domestic economy. This means that even if this scenario emerges, yields might not get that high.

Base Case: Nothing Much Happens

In contrast to the dramatic scenarios outlined above, the base case is that this trade war will have no discernible macro effect. (There will be micro effects on whatever firms or industries are on the wrong side of a new tariff barrier.)

Trump's economic nationalism is running against the globalist reality that American firms have outsourced a wide range of industrial roles decades ago. The location of the outsourcing changed over time; the "giant sucking sound" of job losses used to be coming from Mexico. This was partly to avoid relatively high American wages, and partly to get around environmental concerns. Things might move more rapidly in a geopolitical emergency, but there is little possibility of reversing such a structural shift in a few years.

Meanwhile, the loosening of fiscal policy would help widen the trade deficit because of the increased domestic demand.

Therefore, it is entirely possible that President Trump will wring out some concessions from trade partners. These concessions will be extremely useful for his campaigning in the swing states of the electoral college. However, the effect of any such concessions will be swamped by the tendency of the American trade deficit to widen during an expansion.

That said, foreigners can play a waiting game. President Trump is a singular candidate, and it is unclear whether there is a viable protectionist political movement that will survive him. His unilateral attacks on trading partners risks populist politicians elsewhere responding in kind, creating an environment in which multinational corporations become a natural punching bag. These corporations are very well aware that their success has come in an environment where national legislatures submitted to a rules-based international trade system. Therefore, the top of corporate hierarchies worldwide will push for politicians in all countries to relax, and let President Trump flail around with measures that can be quietly reversed.

Concluding Remark

It is always possible to find tail risk scenarios. The question is whether chasing after these tail risk scenarios is the best use of one's time (or analyst time). In this case, since the outcome seems to be largely driven by personality traits of leaders, it is going to be very difficult to predict the outcome. However, it will be very difficult for even the president of the United States to reverse outcomes that are the result of the institutional forces facing multinational corporations.

(c) Brian Romanchuk 2018