What a week.
Even by the tumultuous standards of the Trump presidency, the last week has been quite busy. Federal Reserve did the warmups, but it was the escalation of the trade war with China, which really got the party started. We are now close to a global currency war, which could easily spin out of control. The damage already inflicted on the real economy is difficult to assess, but clearly there are significant downside risks, including to the US economy. The risk of disruptive global capital flows is significant, and central banks across the world has already started a race to the bottom on interest rates.
Enter Jerome Powell
It all started out with a dud. On July 31, Federal Reserve cut its main interest rate for the first time in eleven year by 25 basispoints to 2.0-2.25 percent. The cut was widely anticipated with speculation more centered on the size of the cut rather than whether Federal Reserve would cut at all. However, it was a more reluctant cut than markets had anticipated.
Federal Reserve maintained the positive view on the US economy, and indeed the latest incoming data have been quite strong. The labor market was described as “solid” and “strong”. While uncertainties were elevated, there was really not much to justify a rate cut. The reluctance was amplified by Chair Jerome Powell’s press conference.
Powell went to great lengths to cast the reversal in monetary policy since the turn of the year as a large overall easing of financial conditions. Hence, the need for more accommodation was not a given. Federal Reserve kept all options on the table, but Powell downplayed the need for a lengthy easing cycle – and the term “monitor closely” was replaced with just “monitor” in the policy statement.
Markets – and President Trump – had hoped for a more decisive Federal Reserve. But given the interest rate cut was mostly an act of self-defense against a president, who holds significant powers over the federal bureaucracy, this was pretty much as little as the central bank thought it could get away with. Certainly, there are headwinds from trade wars and global growth, but the US consumer is doing great.
Enter Donald Trump
President Trump’s decision to add ten percent tariffs to almost all remaining Chinese imports valued at around USD300 billion from 1 September is hardly surprising, but the timing is a conundrum.
The announcement came a day after Powell refused to commit to more rate cuts. Was it an attempt to push Federal Reserve into an easing cycle?
It followed meetings in Shanghai between US and Chinese representatives. Meetings described as “constructive”, which is diplomatic talk for little progress, but still talking. Negotiations had been planned for September. Did Trump lose patience with the China’s foot dragging?
Or was the timing due to the upcoming harvest season of soybeans in the Midwest? October is peak export season for soybeans, and Trump would very much like a firm commitment from China to buy as much as possible. Soybean prices are down 20 percent since the trade war began in earnest last year, and more help for US farmers is probably needed. This is not a winner in Iowa.
Whatever the reason for escalating the trade war right now, it spectacularly backfired. The Federal Reserve most likely will cut interest rates again, but only because the risk of a significant hit to the US economy has increased. Equity markets, one of President Trump’s favorite indicators of the economy, are down sharply. China has reacted angrily and let the yuan weaken to the lowest level against the dollar since 2008. And China has stopped buying US agricultural products. In recent weeks, the US was exporting more soybeans to China than what is usual for the season.
Purchases of soybeans is a Trump precondition for even resuming trade negotiations with China. But China is not likely to resume purchases of soybeans without some US concessions to jumpstart negotations. A stalemate.
The weakening of the yuan is a red line for a president, who has long argued that China is manipulating its currency. On 5 August, President Trump realized that it is his own Treasury – and not the Federal Reserve – which decides whether a country is to be labelled a “currency manipulator”. In a short statement , China was declared a currency manipulator, although China does not fulfill two of the three criteria, the US Treasury has established.
This has not happened since 1994; not even during the years when China obviously was actively intervening to prevent the yuan from strengthening. In order to keep the value of a currency down, the central bank sells domestic currency and buy foreign, thus increasing reserves of foreign currency. Between 2000 and 2014, China’s foreign reserves increased from USD156 billion to USD 3.999 billion.
However, China’s large current account surplus has all but vanished, and the central bank is now intervening to prevent the yuan from declining at a faster pace. The designation of China means that the entire process of assessing currency manipulation has become a rubber stamp for the President’s views. Anyone can now be labelled a manipulator.
And it is likely to happen again as central banks across emerging markets are rushing to cut interest rates – even as their currencies are depreciating. While the trade-weighted dollar is somewhat unchanged since May, the euro has strengthened – also hit hard by the steep decline in British pound as a no-deal Brexit is now the main scenario. Hence, ECB will almost certainly ease monetary policy at its meeting in September. It will be interesting to see how President Trump reacts to that.
What is the cost to the US economy?
President Trump’s decision to add new tariffs increases uncertainty about the outlook for the US economy. So far, tariffs have smartly been applied to mostly capital and intermediate goods with a negligible impact on consumer inflation. Moreover, some substitution effect away from Chinese suppliers have kept costs at bay.
However, auto producers, construction companies and other businesses using imported Chinese commodities have been hit. The federal government’s receipts from custom duties almost doubled between end-2017 and Q2/2019 to USD71 billion and are now set to grow further. These duties are paid by US businesses and to a small extend consumers.
All this is likely to change as consumer goods are added to the list. President Trump clearly believes that lower interest rates would counter the negative effects from the trade war. I do not think so. Businesses do not invest because interest rates are low-ish, but because there is a positive outlook for the US economy. Lower interest rates might support the equity market in the short run, but businesses are likely to freeze capital investments as the uncertainties about US economic growth – and relations with the global economy – have skyrocketed. Consumers will decide how much overall activity is set to slow.
The New York Fed recession index is above 30 percent, and talk of a recession – with a continued market correction – could become self-fulfilling.
What happens now?
The additional tariffs and China’s display of other means of retaliation have brought the trade war onto a new level. Manufacturing optimism has already been hit hard but is likely to dive further. More importantly, businesses can no longer pretend that the trade war is going away soon. If the US administration had been able to stay focused on the original grievance – China’s industrial policies – President Trump would have been able to command a tacit support from the EU and Japan, who fully agrees with the President’s aim of creating a level playing field, enforce intellectual property rights, and do away with the heavy government support for industrial development. But that is no longer what this conflict is about.
However, it should not be forgotten that the direction of the trade war is ultimately decided by President Trump and his personal view on how it will affect the chance for reelection. If the US economy begins to slow in a significant way, Trump can shout all he wants at the Federal Reserve, but the blame is likely to be – at least partly – assigned to the President. It might turn out that a bad deal with China is better (for election purposed) than no deal. By escalating the trade war now, President Trump has weakened his own negotiating position at a time, when he was doing quite well. The risk of new surprise measures is high.
Domestic policies in China also play an important role in the impasse. The economy has slowed, the protests in Hong Kong has brought Beijing in a lose-lose situation, and the celebration of the 70th birthday of the People’s Republic is coming up on 1 October. Rhetoric in the Chinese media has become increasingly defiant regarding the trade standoff, and President Xi is unlikely to show any kind of weakness.
The trade war is not ending any time soon, and it could easily escalate further. The Chinese tech giant Huawei, US sanctions against Iran, and national-security issues are also part of the mix. More market turbulence should be expected in coming months.