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Tariffs spoil the party

The Days Ahead: Light economic calendar. Focus on Germany and Japan.  

One-Minute Summary Things were going so well. Until Thursday when a tweet appeared saying that the China tariffs were back on for September. Guess when the tweet went out?

Now, there’s a story going round that goes like this:

  1. The Fed cut but, in the Administration’s view, not enough

  2. The Fed uses employment and inflation to set rates except…

  3. On Wednesday, the Fed said they cut because of the “implications for global development”

  4. The Administration controls trade tariffs and “global development”

  5. Higher trade tariffs cause more concern and a slowdown

  6. The Fed cuts more

  7. Administration gets its way

Who knows? But it worked. The 10-Year Treasury rallied on Thursday and stayed at around 1.86% on Friday.

We still think a China trade deal will happen but perhaps the tactics are to delay. Or provoke more? Markets were a little complacent in the last few months. After all, trade is slowing, and leading indicators like airfreight, rail movements and shipping containers have all trended down. Trading in August always over reacts so all this may calm down.

We'll continue our defensive strategy. We're likely to trim anything to do with Asia Pacific and return assets to the U.S.

1.     Did the Fed surprise anyone? No. On Wednesday, the Fed announced a 25bp lowering of the Fed Funds rate. That was as expected a few weeks ago but, as always, the market overreached itself and wanted more. This was the first cut in the cycle since September 2007. That’s nearly 12 years. Remember the average Wall Street trader has been in the business for 8 years and the average portfolio manager in place for 10 years. This is the first cut many have seen.

As we've discussed, the economy has slowed but not stopped. Employment is fine. Most consumer activity is fine. So why the cut? It’s all about worries that trade is holding corporate confidence back. And about the lack of inflation.

Here’s what the move looks like (Federal Funds rate in yellow):

The only times that remotely look like 2019 were the mid-cycle cuts in 1995 and 1998. The 1995 cut was from a much higher level, when Federal Funds had doubled in 15 months and with two quarters of weak growth. The 1998 cut was all about the fallout from a hedge fund called LTMC (here’s the full horror story). So both were insurance cuts as in “things aren't too bad, but they look like they could be, so here you go.”

So all pretty much expected. The key parts of the announcement were:

  1. Two governors dissented. That’s more than usual and in the collegial Fed, it’s a problem

  2. Chair Powell talked about a mid-cycle “adjustment” not a “lengthy cutting cycle.” This means he’d like to be done.

  3. The run off in the Fed’s balance sheet will stop. Since late 2018, it’s declined at an annual rate of 12%. That means more Treasury buying as bonds mature.

Initial market reaction was a yawn for the long end, so 10-Year Treasuries barely moved, but a spike in the 2-Year Treasury from 1.80% to 1.96% (that’s a big move in the Treasury world). And that meant, of course, a flatter yield curve. Stocks sold off. They wanted more.

On Thursday, however, the 10-Year moved down to 1.89%, equivalent to a 1% price change. That was down to a tweet announcing an initial 10% tariff on the $300bn of trade not yet subject to tariffs. The price action was probably overdone but it confirms our confidence in Treasuries.

But putting this all together, we’re probably done on the rate side for a while. Unless the growth really deteriorates between now and late fall, or inflation drops, we think rates will stay where they are for the September meeting.

2.     Aww, come on. This is something you don't see often.

That yellow line is the yield curve of the German Government Bond market (Bunds). It’s not also inverted (that's old news) but it’s entirely below zero. So if you buy a 6-month bill, you will receive €996 in time for the Holidays. If you buy €1,000 of a 10-Year Bund at par, you will receive €950 in 2029. And if you go all in and buy a 30-Year bond, you will receive no coupon and your €1,000 back in 2049. With a big thank you from the German government (h/t FT Alphaville).

There seems no end to the era of negative and zero rates. For us, this points to very mediocre growth in the world’s fourth largest economy.

3.     Update to our South Korea story.  Japan took South Korea off the “white list” of preferred export markets. This means the vital raw materials for chip production won't find their way to South Korea easily. The Korean stock market was an ocean of red on Friday.

4.     How about the employment report?  Normally a headline grabber, but this month’s employment report was overshadowed by trade tweets. The headline number was in line. This is how it looks:

  1. But all was not good. Here's a quick take:

  2. Downward revisions of 41,000 for the prior two months.

  3. The three-month total is down to 421,000 from 521,000 earlier this year.

  4. No dent on the underemployment number or…

  5. Average hourly earnings

The market had other things on its mind. But this shows slowing but not stopped job creations.

Bottom Line: Some caution is needed. Bonds have rallied fast and far. The economy is not going to respond to lower rates. International has had a good run this year and it's perhaps time to take some money off the table.

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We’ll start attributing the art in the blogs. This week:

Art: Elaine de Kooning (1918-1989)

--Christian Thwaites, Brouwer & Janachowski, LLC

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All charts from Factset unless otherwise noted.

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