Now that the market has digested the initial shock following Trump’s surprise threat to raise the 10% tariff on $200BN of Chinese goods to 25% on May 10 in what BofA has called a “major escalation”, traders and investors are focusing on three follow up questions: i) why did Trump do what he did, ii) is he serious and iii) is the possibility for a trade deal with China now dead?
First, looking ahead, RaboBank’s Michael Every writes this morning that Trump’s pivot “puts chief negotiator Liu He in a very awkward position. While it may be Trump’s style to be impulsive in the final stages of a deal, the Chinese government will lose face if they cave in to his demands following a public threat on Twitter. It could be perceived as a breach of trust and the Chinese may conclude that the US have been negotiating in bad faith after all. But only when they decide to walk away and announce their retaliation, will we truly know Trump’s intentions. Is he really willing to cancel trade talks, and to put the recent rally of his beloved stock market at risk? And this with just 18 months left before the US elections? Or will he somehow regain control over his emotional intelligence and still find a way around this strong 10 May deadline?”
So while the future remains murky, and the ball is now in China’s court, a better answer may come from analyzing another, just as important question: how did we get here in the first place? According to BofA, the answer is that “economic and market strength has reduced both sides’ incentives to compromise.“
And while that may sound intuitive, when policy is very responsive to markets, the policy/markets equilibrium can be elusive. The result is increased volatility.
So what to expect? Below is the latest primer from Bank of America’s global economist Aditya Bhave, explaining “what happened to the trade deal” and what to expect next.
Soon after the Xi-Trump summit in Buenos Aires last December, we highlighted an interesting relationship between policy and markets. At the time we argued that weaker markets were pushing policymakers towards a more benign outcome on trade. But we flagged the risk of an extended period of uncertainty: if the markets started to price a positive outcome, the urgency to reach a deal would reduce.
Now, with the S&P 500 basically at its all-time high, President Trump has unexpectedly threatened to increase the tariffs against China on Friday (May 10). This is the most significant escalation of the US-China trade war to date. We take this opportunity to explore our theory in more detail. The interaction between trade policy and markets shown in Chart 1 below is conceptually similar to countercyclical traditional (fiscal or monetary) policy, with policy measures mitigating shocks in either direction.
But there are two key differences:
- First, traditional policy typically responds primarily to economic shocks. By contrast the current US administration has been very sensitive to the markets. We think this could lead to more frequent policy shifts because markets are more volatile than the underlying economy.
- Second, the markets understand the traditional policy response function and price it in before the fact. But if countercyclical policy shocks are not fully anticipated, as has arguably been the case with trade policy, very responsive policy increases market volatility. We show that in this case markets and policy tend to spiral away from equilibrium until the markets learn to internalize the policy response function.
The immediate market response suggests that the latest escalation of the trade war was a complete surprise to investors. This means that markets could be in for a bumpy ride before a trade deal is reached.
We have been calling for a benign outcome on the US-China trade war. Our view has been that a full-blown trade war would be avoided because pain in the markets, the economy and in public opinion polls would force policymakers to compromise. But importantly this sort of pain is not just sufficient to incentivize a trade deal, it is also necessary. This is why our mantra has been “no pain, no deal.” The implication is that there are likely to be speed bumps along the path to an agreement: improvements in market sentiment or economic fundamentals might prompt policymakers to dig their heels in and negotiate harder.
The latest news might not just be a speed bump. If President Trump acts on his threat to raise the 10% tariff on $200bn of Chinese goods to 25%, that would represent a detour, at the very least. There are several reasons why the threatened tariff increase would be the most significant escalation of the trade war to date.
- First, assuming no FX or price adjustments, it would amount to an additional $30bn tax on US consumers and firms, representing the largest single round of tariff increases since the trade war began.
- Second, this round of tariffs includes more consumer goods-nearly a quarter-than prior rounds, which focused more on capital and intermediate goods.
- Finally, it will be difficult for currency markets to offset the effect of the latest threatened tariffs. FX has been playing the role of shock absorber in the trade war: when the trade war looked to be getting worse last fall, the renminbi was down nearly 9% against the US dollar.
This move almost negated the effect of the 10% tariffs. Since then news of reconciliation has caused the currency to appreciate. With Chinese policymakers looking to prevent large currency moves, we think it is highly unlikely that they would allow the renminbi to depreciate enough to offset a 25% tariff.
Why the sudden escalation of tensions while negotiations are ongoing? President Trump cited the lack of sufficient progress in trade talks. The latest threat is undoubtedly an attempt to speed up negotiations, and perhaps to extract more compromises out of China, which so far does not appear to have conceded ground on any major issues. But it is hardly a coincidence that the threat comes with equity markets around their all-time highs and with the Fed having taken a very dovish turn. The markets are now better buffered than they were last fall against a negative surprise on trade. Equally we would not be surprised if Chinese negotiators have hardened their stance in response to improved domestic data.
A simple framework
Here we develop a simple framework to explore the relationship between policy and markets. In Chart 1, the upward-sloping line is the market response to policy: the markets respond positively to benign policy and negatively to less friendly policy. The downward-sloping line is the policy response to markets. Weak markets motivate friendly policy and strong markets do the opposite. Markets and policy are in equilibrium where the two lines cross.
This framework is not entirely new. It is conceptually similar to traditional countercyclical monetary and fiscal policymaking. For example, markets are stronger when they expect a dovish Fed, but strong markets (and a strong underlying economy) tend to make the Fed more hawkish. But there are a couple of important differences between traditional countercyclical policy and countercyclical protectionism.
The first is that monetary and fiscal policy are typically more responsive to economic fundamentals than market gyrations. Since the markets are more volatile than economic data, traditional policy does not change course very often. By contrast, the current US administration appears to keep a close eye on the markets. This results in more frequent swings in trade policy. As an aside it is somewhat ironic that trade policy has become countercyclical after a large procyclical tax cut and a somewhat procyclical turn in monetary policy.
The second difference between current trade policy and standard monetary policy is that the latter is well understood by the markets and gets priced in before the fact. For example, equity markets respond positively to good economic news, but there is also some financial tightening because rates increase in anticipation of a more hawkish Fed.
Chart 3 below shows the impact of a positive exogenous shock. For example, the recent upside surprise in Euro area GDP has likely moved the market response function upwards: for a given policy stance, the markets will be stronger than they would have been if the Euro area data had been softer. A countercyclical policy response to the exogenous shock implies slightly tighter / less-market-friendly policy. If the markets understand the policy response function, they will converge quickly to the new equilibrium, with stronger markets despite less friendly policy.
What if the markets do not understand how policymakers will respond? Then Chart 4 shows in our view how the new equilibrium might be reached. Stronger markets lead to less friendly policy, which weakens the markets, which leads to more benign policy, and so on. In other words, markets will gyrate on the path to the new equilibrium.
But there is an even more concerning possibility. What if, instead of converging to a new equilibrium, markets and policy spiral away from it, as in Chart 5? That is, what if each move in the markets causes an increasingly larger policy response, and vice versa? In that case we think market volatility will be exaggerated, and equilibrium will only be reached when the markets “learn” the policy response function.
The difference between Chart 4 and Chart 5 is the responsiveness of the policy function. It is precisely when policy is very responsive to markets that we might spiral away from equilibrium instead of converging to it.
Fasten your seatbelt and don’t hold your breath.
What does our framework say about the outlook? The good news is that the markets seem to be coming to grips with the US administration’s policy response function. That is arguably why markets were volatile last year but have been less responsive to news out of Washington, good or bad, in recent months.
The bad news is that the latest escalation of the trade war was completely unexpected, despite the strength of the economy and the markets. This is evident from the immediate negative reaction of US equity futures to the news. However we cannot rule out the possibility that President Trump does not plan to act on his threat, which might have been made simply to raise the profile of an imminent deal. It is also possible (though very unlikely in our view) that China will suddenly make a major compromise, triggering a deal and precluding the tariff hike. However, given that trade policy has proven to be even more responsive to the markets than was generally believed, our framework makes a strong case against complacency. We believe we might be in for a long, bumpy ride before a trade deal is finally reached.
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