Much like Blanche DuBois in Tennessee Williams’ play “A Street Car Named Desire,” the U.S. has “always depended on the kindness of strangers,” or at least it has for quite a long time. That’s because foreigners have been big buyers of bonds issued by Americans. They’ve helped to finance the U.S. federal budget deficit. They’ve also bought lots of mortgage-backed and corporate bonds.
President Donald Trump’s escalation of the trade war between the U.S. and all our major trading partners has raised concerns that foreigners will respond to Trump’s “America First” protectionism by cutting back on their purchases of U.S. debt. Furthermore, Trump’s tariffs may boost inflation in the U.S. by increasing the cost of imports. Both possibilities should be bearish for bonds. Yet bond yields remain eerily subdued. Let’s consider why, and also whether tariffs are necessarily inflationary:
1. Bond yields and expected inflation: The 10-year U.S. Treasury TMUBMUSD10Y, +0.32% yield peaked at 3.11% on May 17, and has been trading below 3.0% most of the time since then (Fig. 1). The comparable 10-year TIPS yield has mirrored the nominal yield so far this year.
Expected inflation, meanwhile, as implied by the spread of the two yields, has been relatively stable around 2.0% after mostly rising during the second half of 2017 from a low of 1.66% on June 21, and jumping after passage of the Tax Cuts and Jobs Act (TCJA) last December 22. (Fig. 2).
The escalating trade war hasn’t yet boosted the expected-inflation spread, despite Trump’s threat to impose tariffs on lots of Chinese imports. So far, there is no sign that foreigners are bailing out of U.S. debt securities. On the contrary, the outbreak of protectionist saber-rattling, and now jousting, has boosted the trade-weighted U.S. dollar DXY, +0.11% (Fig. 3). This suggests that some global investors are taking sides in the trade war, betting that the U.S. will win — if there is a winner — or at least will emerge the least-bloodied. And, of course, the U.S. government bond yield is highly attractive relative to the near-zero yields of comparable German and Japanese bonds.
Meanwhile, despite the potential for a trade war to cause a global recession, the credit-quality yield spread between high-yield corporate bonds and the 10-year Treasury also remains eerily serene. The spread has been in a tight range around 3.5 percentage points since early 2017 (Fig. 4).
Trade-war tracker: Here are the new levies, imposed and threatened
2. Doctor copper: The price of copper has been falling since it peaked this year at 329.3 cents per pound on June 8 (Fig. 5). Copper prices continued to move lower last week, closing at 277.0 cents, down 15.9% from the recent peak. Since this says more about the economy of China than that of the U.S., it’s not surprising to see that Chinese stocks are getting hammered (Fig. 6).
In the U.S., the S&P 500 SPX, +0.22% and its S&P 400 and S&P 600 counterparts are up 8.5%, 10.8%, and 17.1%, respectively, since their lows on February 8. My switch back to a “Stay Home” from a “Go Global” investment strategy on June 4 was well-timed, so far, as evidenced by the ratios of the U.S. MSCI index to the All Country World ex-US MSCI index in both dollars and local currency terms. Both benchmarks soared to record highs last week (Fig. 7).
3. Flow of funds: As I discuss in my book, Predicting the Markets, I use the Fed’s quarterly report Financial Accounts of the United States to monitor the flow of funds in the capital markets. The data are currently available through the first quarter of 2018. They show that the “rest of the world” acquired $674 billion in U.S. fixed-income securities over the past four quarters (Fig. 8). That’s among the highest readings since the 2008 global financial crisis. This latest figure includes $332 billion in Treasurys and $267 billion in corporate bonds (Fig. 9 and Fig. 10).
The consensus view among economists is that Trump is wrong about trade wars. They aren’t “good, and easy to win,” as he tweeted on March 2. It is also widely believed that if Trump continues to intensify the trade war, everyone will lose because the result is most likely to be stagflation or worse. Weakening global trade will depress global growth, while higher tariffs will boost inflation. I’m not dismissing this widely held narrative. But while Trump has opened many fronts in his battle for fair trade with America’s major trading partners, the major fight is with China.
Will China put up the white flag and make major concessions to get a cease-fire out of Trump? Currently, that seems unlikely. But that’s exactly the story being told by the financial markets. Recall that Chinese stocks are falling, and U.S. stocks are rising. The weakness in the price of copper is a better economic indicator for the economy of China than for that of the U.S.
While the Fed continues to gradually normalize monetary policy, the People’s Bank of China has cut reserve requirements sharply in recent weeks (Fig. 11). That undoubtedly contributed to the 6.2% plunge in the yuan USDCNY, -0.0655% from its mid-April peak (Fig. 12).
If Trump does raise the ante by slapping a 10% tariff on $200 billion of imports from China, a stronger dollar relative to the yuan might offset most of the inflationary consequences for the U.S. To add insult to injury, Trump could revive his attacks on China as a “currency manipulator.” My sense though is that U.S. trade policies, not Chinese intervention, is weakening the yuan.
Trump understands that a weak yuan could cause the Chinese some real pain, by increasing the yuan cost of buying dollar-priced commodities, especially oil. China’s PPI inflation rate, which was 4.7% on a year-over-year basis in June, could go higher and put upward pressure on the CPI inflation rate, which was 1.9% last month (Fig. 13).
Meanwhile, in the U.S., year-to-date performances through the end of last week of the S&P 500 sectors suggest that investors are more concerned about rising interest rates resulting from a strong economy than about a trade war depressing the economy (Fig. 14). Cyclical S&P 500 stocks are mostly outperforming interest-rate sensitive ones: Information Technology (15.3%), Consumer Discretionary (14.1), Health Care (5.8), Energy (5.7), S&P 500 (4.8), Real Estate (-0.1), Utilities (-0.3), Industrials (-2.8), Materials (-3.1), Financials (-3.5), Consumer Staples (-7.8), and Telecom Services (-10.3).
Ed Yardeni is president of Yardeni Research, Inc., a provider of global investment strategy and asset allocation analyses and recommendations. He is the author of “Predicting the Markets: A Professional Autobiography.” (2018). Follow him on Twitter and LinkedIn.