Economics and Strategy

Fed Policy vs Trade Policy: It’s Not Even a Contest

It’s so depressing to watch the world of mainstream economic punditry try to blame its epic 2019 forecasting failures on trade policy changes. The number of high-profile folks who were in the 3.5% to 4% 10-year note camp, as well as the three-to-four rate-hike camp, for 2019 who have now become trade-warmongering uber-doves is actually shocking. Just to be clear, so far $200 billion of goods from China, representing about 1% of U.S. GDP, are subject to a 25% tariff. And that’s supposed to topple the $20 trillion U.S. economy?? Pullleaasee.

Now, I know that indirect effects on business sentiment and retaliatory effects on exports COULD add to further deterioration. And of course there are more serious escalation risks as trade policy looks to weaponize for noneconomic purposes, as in regard to Mexico. But none of this has really happened yet. And even if we did go down that darker path, the largest indirect effect from additional actual and potential trade policy shifts is something far more powerful in the POSITIVE direction: Fed policy changes.

In recent weeks we have heard Powell, Clarida, and Evans all basically say the same thing: they are monitoring economic developments closely, and they will act accordingly if conditions deteriorate. Of course, Bullard has gone a step farther to speak of immediate cuts given the inflation target misses of the last seven years - but that’s just a repeat of his long-standing (and in my opinion correct) view. The new story here is that the powerbase of the FOMC brought our beloved spoo put strike right into viewing distance. And it’s this same put, which has crushed the haters at every turn of the recovery for the last 10 years, that will no doubt demolish this exiguous threat from trade.

On Monday, June 3, prior to all the Fed speeches at the framework change conference in Chicago, I put forward some possible put strike levels. And after wading through all these new communications, I had no reason to change those {x,y,z} strike levels of {2625,2500,2375}. I believed (and still do) that they had just told us that if we go down ~10% from the all-time highs of around 2950, then the lift-off turns into a nosedive. It’s that simple. And the haters best get out of the way as that nosediving rate missile is headed right for their short-biased risk asset portfolios. Now, two weeks later here we sit right back at ~2950, making new highs.

All of this said, I do want to make one other very important point on this whole trade saga flip-flop by the mainstream economic forecasting mob. In my opinion, the modest slowing that began in late 2018 has come from those standard, well-established, long and variable lags associated with the monetary tightening. Over the last two years the Fed has taken policy rates up over 200 basis points and executed $800 billion in QT. And I would argue this balance sheet move is easily worth ~100 basis points of rate tightening. It was this LARGE tightening, and the hawkish Powell communication errors in Q4, which led to the economic and financial-market jitters we have seen in recent quarters. Trade has been a VERY minor factor, and arguably one that can be EASILY offset by the appropriate application of modest doses of monetary stimulus. To see sell-side, academic, and central bank economic forecasters fall back on trade concerns to cover their mistakes is just pathetic. These folks thought neutral rates were 4%. These folks thought end-of-cycle inflation spikes were coming. And these folks thought the Fed was going to overshoot on policy-rate tightening moves. They were wrong about neutrality, wrong about inflation, and wrong about their calls for both rates and risk assets. To try to blame that failure on a few tweets and some modest tariff moves is disgraceful.

Anyway, enough on that. Spoos are right back at all-time highs. Imagine if they went full Bullard and decided to actually initiate the nosedive in rates from here. We would be at new all-time highs in a heartbeat, even if all $565 billion of Chinese imports went under a 25% tariff and the Mexican tariffs went into effect. Oh yeah, and if trade issues escalate any further, and folks worry that the Fed will run out of ammo, don’t forget that the balance sheet is ready, willing, and able to head right back to its highs of $4.6 trillion or even well beyond. Spoos, blues, and seagulls all feel just fine.

David Zervos, Chief Market Strategist