I'll be seeing you at the zero lower bound bud

Summary

• Tariff update — What changed this week?

• US interest rates — The inevitable stumble to zero. 

• Markets are on a knifes edge — Slip and slide conditions.

Event risk continued to be the main driver in markets over the week with the latest escalation in tariffs between the US and China showing that a trade deal is nowhere in sight. Markets were fairly rangebound over the week until news broke early Friday that China would be imposing $US 75 billion worth of tariffs on the US. It didn’t take long for the US to strike back, hitting China with an additional 5 percent tariff on around $US 550 billion of Chinese goods. At this point, I think there’s value in going back and seeing how this trade war has developed over the past year — If not to prove just how absurd this has become then to add context to the numbers above. I’m sure everyone is sick of hearing about the “trade war” and these numbers have probably become meaningless to some people. To recap what has happened, the additional 5 percent increase is referring to the goods that were announced in September of 2018 (which were set at 10 percent and escalated to 25 percent, accounting for roughly US$ 250 billion). Those goods were set to be taxed at the start of 2019 but a trade truce in Argentina helped delay the tariffs until May 5, when President Trump broke the truce (implementing them on May 10th). At that time, the President of the US also announced that the US administration was considering an additional 10 percent on the remaining US$ 300 billion of imports from China. So what changed this week? Well, the original US$ 250 billion of imports that were taxed at 25 percent are now being taxed at 30 percent and the additional 10 percent on the US$ 300 billion has increased to 15 percent and will now kick in on the 1st of October. Tariffs on the consumer goods that were delayed to December 15 will still be implemented on the 15th but will now be 15 percent instead of 10 percent. Markets weren’t enamoured with the recent developments and some bank analysts highlighted that the recent escalation signals an increasingly probable scenario in which interest rates in the US fall back to zero. Jerome Powell’s speech on Friday helped reinforce this notion of interest rates going back to zero.  Powell’s speech at the Jackson Hole economic symposium set the stage for an inevitable march back to the effective lower bound in the US. Before all of the shenanigans that unfolded on Friday, the market's ears were already perked, focusing on Powell’s speech, looking for reinforcement that the Fed would continue to cut interest rates (that this was the beginning of a cutting cycle — Keeping the dream alive). Powell had failed to deliver this message at the last FOMC by coaching the rate cut as a “mid-cycle adjustment”. The President helped keep interest rate cuts on the table by escalating trade tensions (essentially engineering further rate cuts by creating uncertainty). The set up for Friday was concerning given the broad consensus among the FOMC from the, albeit stale, meeting minutes that were released earlier last week. Ultimately, Powell’s speech focused on plenty of international developments, alleviating fears that the Fed was insensitive or unresponsive to international developments. The speech also emphasized the failure of the labor market to deliver inflation to the broader economy. With unemployment running at all-time lows, the basic idea is that the supply of workers tightens (giving workers more bargaining power), raising wages and costs of production which then feed through to consumer prices (assuming companies preserve their margins). For the economic geeks, I am talking about the Philips curve and more broadly the argument that this relationship is now dead. There are plenty of reasons why this relationship would be dead — a more convincing one is that workers have lost bargaining power over the years. Regardless of the reasons why this relationship is broken, the fact that Powell continues to mention his concern about unemployment and inflation tells us that there is some doubt that the domestic economy will have enough “oomph” to bring inflation back to target. When you consider that we are in a world of "competitive easing" (race to the bottom stuff from central banks), the longer the Fed holds off from cutting rates, the stronger the US dollar gets (a stronger greenback is inherently deflationary since it lower import prices). There's this feeling in the market that the Fed will have to cut rates regardless if a recession makes landfall due to the downside risks this environment has created to inflation. Long-term US inflation expectations have hit record lows and it's not like things across the pond are looking any better. The ECB (European Central Bank) meeting minutes this week confirmed that Mario Draghi will deliver an easing package in September and, with the Japanese Yen continuing to appreciate on safe-haven flows, it will be just a matter of time before the Bank of Japan has to step in as well (although i’m not sure what they can do — They already own everything in Japan!).  We’re set up for a fairly choppy week with China setting the Yuan (CNY) at new highs and the dealer community generally short gamma. As thing stand Sunday evening, we’re prepping for steep losses in Asia which are likely to carry through to western markets. US futures are down about a percent on the wake of the news on Friday as well as the PBOC (Peoples Bank of China) setting the CNY Fix at a new high. The recent move in the currency shows China's willingness to let their currency absorb the impact of the tariffs and more directly shows that China is tired of being the adult in the room in these negotiations. There is a broad push into safe-haven currencies and there appears to have been a flash crash in the Japanese Yen/ Turkish Lira cross. Gold has been bid higher and oil prices are trading about a percent lower. On the surface, this looks like traders are gathering their thoughts from the developments on Friday and over the weekend in thin and illiquid markets but, none the less, emphasize the negative sentiment in the market. We're likely to see some pretty dramatic moves in the coming sessions as the dealer community is expected to be short gamma. The chart below comes from Charlie McElligott at Nomura and shows the net positioning on the dealers Friday morning BEFORE trade escalations.

Since Friday dealers have likely become even shorter gamma. As a reminder, when dealers are net short gamma this means that they are hedging with the market and will be exasperating volatility. CTAs (momentum trading funds) are short gamma strategies as well but, thankfully, these funds are only expected to be selling S&P500 futures at around 2852 (Nomura's estimates) which is well below current levels. Although we have some activity and manufacturing data this week, the broader picture is one of indecision. From protests in Hong Kong, escalating trade conflicts and negative interest rates many people seem to think this is the “new normal” while others are arguing that this environment is simply unsustainable. I’m not sure what camp I fall in but, If I had to put last week developments into the simplest terms going forward, I would say that the latest string of escalations will provide us with more of the same. Global growth will remain under pressure, forcing central banks to provide more accomodation, providing more support for the US dollar. Competitive easing amongst policymakers will increase the share of negative-yielding debt, supporting more risk-taking and creating further excess supply (search for yield will continue to support zombie companies who are, for the most part, insolvent). Central banks will be left with rates at the effective lower bound with no ammo left to fight a recession. I guess an eye for an eye really does leave everyone blind.

Tiago Figueiredo