Treasuries are trying to stabilize after yesterday’s bludgeoning and while the gains are slight they are at least gains. The ranges that had been in place for most of the summer on 10’s (2.80% to 3.00%) have been broken to the upside. The next support level is the May high of 3.11%. While the market is certainly oversold and the selling has its roots in a variety of sources (more on that below), the momentum could still carry yields to year-to-date highs. If those levels are tested we think the fundamental rationale for higher rates on the long-end is tepid enough to get us buying at or near the YTD highs. Meanwhile, the short-end remains in a bear market expecting hikes in September and December and likely a couple more in 2019. With the 2-year at 2.80%, a 3%-handle is well within reach in the next month. If the 10-year remains more range bound between 3.00% and the YTD high of 3.11% a flat-to-inverted curve seems likely before year-end. As we’ve mentioned before once that happens, despite some Fed rhetoric to the contrary, the decision to continue hiking into an inverted curve (’this time is different’), will become more challenging. Thus, the 2019 FOMC meetings will be a lot more interesting than the 2018 versions.
|Economic News||China Currency Resists Decline After Latest Tariffs||Agency Indications|
We mentioned in the Monday edition that trade machinations would generate most of the headlines this week given the dearth of first-tier economic releases, and the Fed in verbal lockdown until the FOMC meeting next week. That has proven to be the case but what has surprised us some is the lack of market action that we would have expected.
Putting tariffs on an additional $200 billion in Chinese goods one could have reasonably thought would bring about a risk-off trade but that hasn’t happened. After a halting start yesterday equities found their footing and rallied strongly and that reverberated back into Treasury selling as the flight-to-safety trade failed to materialize, even with the Chinese announcing a retaliatory tariff on $60 billion in U.S. goods headed to China. The Chinese also said the U.S. action puts future talks with the U.S. at risk. Meanwhile, the U.S. stated that if China retaliated it risks tariffs on an additional $265 billion in goods which, when considering previous tariffs, would essentially cover all China trade with the U.S.
The collective shrug of the market to the latest trade salvo has its roots in a few explanations. One is that the 10% tariff rate was at the low end of estimates and essentially “baked-in” to the market already. The second point is the 10% to 25% ramp is likely a conditional number that could be a negotiating stick that turns into a carrot if the Chinese offer good faith concessions in the interim. The third and perhaps biggest reason is the calm reaction in the Chinese currency market. Past tariff announcements were met with yuan depreciation such that it effectively offset the cost impact to Chinese exports (see graph below).
Additionally, the 10% tariff is effective September 24th with duties set to rise to 25% in January, with the delay ostensibly to allow American businesses time to find alternative supply chains. Keep in mind those supply chains were developed and refined over years of increased global trade, but whatever, you get three months to adjust. Good luck. As, mentioned above it’s more likely the 25% ramp is a negotiating maneuver.
As mentioned, the most recent announcement didn’t elicit much of a response in the yuan. If the yuan had weakened again as in past tariff episodes it would have most likely generated a much more volatile reaction as emerging market countries would likely need to match the depreciation and that cohort is already suffering from previous rounds of currency depreciation.
The somewhat docile market reaction, however, shouldn’t dissuade one from thinking these trade tariffs can happen with no ill-effects on the economy. Implementing 10% tariffs, or higher, on over $500 billion in goods will be felt in one form or another. What’s more insidious is that much of what we import from China are component/intermediate goods which are part of some other finished product. The tariff cost, therefore, is likely to be obscured to the consumer but make no mistake a higher cost for the end product, or thinner margins to the seller, are the end results.
Thus, the concept of tax saliency becomes an issue here. That is a tax that is easily observable and immediately payable is more readily resisted and protested whereas a tax that is hidden in the cost of the good or deferred is not protested as much, but the consumer may resist in the form of reducing his/her purchases. He sees the higher cost, isn’t sure where it comes from but elects to avoid the cost increase by not purchasing the good/service.
What that means is that while the tariff is flowing to the consumer they won’t see it as directly responsible for the price increase and therefore won’t overtly protest. Rather they will resist at some point by shutting their wallets due to the higher cost. So the knee-jerk Treasury reaction of higher tariffs flowing to higher goods costs thereby increasing general price/inflation levels is logical. The longer-run impact, however, is likely reduced spending/purchasing power by consumers and/or reduced profit margins to sellers. Both of those outcomes will stymie economic output at some point. That implies to us a limit to any knee-jerk selling in Treasuries from perceived cost pressures, and thus we would be standing by with dry powder when this crescendo of selling has passed.
China Currency Resists Decline After Latest Tariffs
The escalation of the trade war with China didn’t lead to a risk-off trade and in fact did the opposite with stocks rallying and Treasury yields moving to the top of recent ranges. One reason given for the sanguine market reaction is that the Chinese yuan didn’t decline in the face of the latest round of tariffs like it did in earlier iterations. The graph shows yuan levels (inverted for ease of reading) over the last year with the major decline occurring in May and continuing through the summer as initial tariffs were mostly offset with a cheapening currency, most likely with the tacit agreement of central bank officials. The summer yuan devaluation helped ignite the emerging market currency crisis but the lack of another leg lower in the yuan from the latest tariffs has likely worked to calm risk markets, for now.
Agency Indications — FNMA / FHLMC Callable Rates