President Trump shocked markets yesterday when he announced that a new, heavy round of tariffs on Chinese goods will take effect this Friday. Complacent markets had assumed that a trade deal would get done, that it was just a matter of sorting out the details. Now that is far from certain. Failing a last minute deal, which is certainly possible, the trade war is back. And it could get worse.
What most surprised me about the new trade war was not that it started, but that the mainstream financial media denied it was happening for so long. The media have consistently denied the impact of this trade war. Early headlines said that Trump was bluffing and would not follow through on the tariffs. He did. Later headlines said that China was just trying to save face and would not retaliate. They did.
Today the story line has been that the trade war will not have a large impact on macroeconomic growth. It will. The mainstream media have been wrong in their analysis at every stage of this trade war. And it did not see this latest salvo coming.
The bottom line is that the trade war is here, it’s highly impactful and it could get worse. The sooner investors and policymakers internalize that reality, the better off they’ll be.
For years I’ve been warning my readers that a global trade war was likely in the wake of the currency wars. This forecast seemed like a stretch to many. But it wasn’t.
I said it would simply be a replay of the sequence that prevailed from 1921–39 as the original currency war started by Weimar Germany morphed into trade wars started by the United States and finally shooting wars started by Japan in Asia and Germany in Europe.
The existing currency war started in 2010 with Obama’s National Export Initiative, which led directly to the cheapest dollar in history by August 2011. The currency war evolved into a trade war by January 2018, when Trump announced tariffs on solar panels and appliances mostly from China. Unfortunately, a shooting war cannot be ruled out given rising geopolitical tensions.
The reasons the currency war and trade war today are repeating the 1921–39 sequence are not hard to discern. Countries resort to currency wars when they face a global situation of too much debt and not enough growth.
Currency wars are a way to steal growth from trading partners by reducing the cost of exports. The problem is that this tactic does not work because trade partners retaliate by reducing the value of their own currencies. This competitive devaluation goes back and forth for years.
Everyone is worse off and no one wins.
Once leaders realize the currency wars are not working, they pivot to trade wars. The dynamic is the same. One country imposes tariffs on imports from another country. The idea is to reduce imports and the trade deficit, which improves growth. But the end result is the same as a currency war. Trade partners retaliate and everyone is worse off as global trade shrinks.
The currency wars and trade wars can exist side by side as they do today. Eventually, both financial tactics fail and the original problem of debt and growth persists. At that point, shooting wars emerge. Shooting wars do solve the problem because the winning side increases production and the losing side has infrastructure destroyed that needs to be rebuilt after the war.
Yet the human cost is high. The potential for shooting wars exists in North Korea, the South China Sea, Taiwan, Israel, Iran, Venezuela and elsewhere. Let’s hope things don’t get that far this time.
But the easiest way to understand the trade war dynamics is to take Trump at his word. Trump was not posturing or bluffing. He will agree to trade deals, but only on terms that improve the outlook for jobs and growth in the U.S. Trump is not a globalist; he’s a nationalist. That may not be popular among the elites, but that’s how he sets policy. Keeping that in mind will help with trade war analysis and predictions.
Trump is entirely focused on the U.S. trade deficit. He does not care about global supply chains or least-cost production. He cares about U.S. growth, and one way to increase growth is to reduce the trade deficit. That makes Trump’s trade policy a simple numbers game rather than a complicated multilateral puzzle palace.
If the U.S. can gain jobs at the expense of Korea or Vietnam, then Trump will do it; too bad for Korea and Vietnam. From there, the next step is to consider what’s causing the U.S. trade deficit. This chart tells the story. It shows the composite U.S. trade deficit broken down by specific trading partners:
The problem quickly becomes obvious. The U.S. trade deficit is due almost entirely to four trading partners: China, Mexico, Japan and Germany. Of those, China is 64% of the total.
President Trump has concluded a trade deal with Mexico that benefits both countries and will lead to a reduced trade deficit as Mexico buys more U.S. soybeans.
The U.S. has good relations with Japan and much U.S.-Japanese trade is already governed by agreements acceptable to both sides. This means the U.S. trade deficit problem is confined to China and Germany (often referred to euphemistically as “Europe” or the “EU”). The atmosphere between the U.S. and the EU when it comes to trade is still uneasy, but not critical.
But the global trade war is not global at all but really a slugfest between the U.S. and China, the world’s two largest economies. In the realm of global trade, the United States is an extremely desirable customer. In fact, for most, we are their best customer.
Think the still export-based Chinese economy can afford to sell significantly less manufactured goods across borders? Think that same Chinese economy can allow for a significant devaluation of U.S. sovereign debt? That’s their book, gang.
But China has finally come to the realization that the trade war is real and here to stay. Senior Chinese policymakers have referred to the trade war as part of a larger strategy of containment of Chinese ambitions that may lead to a new Cold War. They’re right.
Trump seems to relish the idea of bullying the Chinese in public. That’s certainly his style, but it’s also a risky strategy. To quote Sun Tzu: “Do not press a desperate foe too hard.”
China doesn’t like to be chastised publicly any more than anyone else, but culturally, saving-face may be more important to the Chinese. The Chinese are all about saving face and gaining face. That means they can walk away from a trade deal even if it damages them economically. Saving face is too important. But Trump is playing for keeps and will not back down either.
Unlike in other policy arenas, Trump has enjoyed bipartisan support in Congress. The Republicans have backed Trump from a national security perspective and the Democrats have backed him from a pro-labor perspective. China sees the handwriting on the wall.
This trade war will not end soon, because it’s part of something bigger and much more difficult to resolve. This is a struggle for hegemony in the 21st century. The trade war will be good for U.S. jobs but bad for global output. The stock market is going to wake up to this reality. The currency wars and trade wars are set to get worse.
Investors should prepare.
We all know the outlines of how the Fed and other central banks responded to the financial crisis in 2008.
First the Fed cut interest rates to zero and held them there for seven years. This extravaganza of zero rates, quantitative easing (QE) and money printing worked to ease the panic and prop up the financial system.
But it did nothing to restore growth to its long-term trend or to improve personal income at a pace that usually occurs in an economic expansion.
Now, after a 10-year expansion, policymakers are considering the implications of a new recession. There’s only one problem: Central banks have not removed the supports they put in place during the last recession.
Interest rates are up to 2.5%, but that’s far lower than the 5% rates that will be needed so the Fed can cut enough to cure the next recession. The Fed has reduced its balance sheet from $4.5 trillion to $3.8 trillion, but that’s still well above the $800 billion level that existed before QE1.
In short, the Fed (and other central banks) have only partly normalized and are far from being able to cure a new recession or panic if one were to arise tomorrow. It will takes years for the Fed to get interest rates and its balance sheet back to “normal.”
Until they do, the next recession may be impossible to get out of. The odds of avoiding a recession until the Fed normalizes are low.
The problem with any kind of market manipulation (what central bankers call “policy”) is that there’s no way to end it without unintended and usually negative consequences. Once you start down the path of manipulation, it requires more and more manipulation to keep the game going. Finally it no longer becomes possible to turn back without crashing the system.
Of course, manipulation by government agencies and central banks always starts out with good intentions. They are trying to “save” the banks or “save” the market from extreme outcomes or crashes.
But this desire to save something ignores the fact that bank failures and market crashes are sometimes necessary and healthy to clear out prior excesses and dysfunctions. A crash can clean out the rot, put losses where they belong and allow the system to start over with a clean balance sheet and a strong lesson in prudence.
Instead, the central bankers ride to the rescue of corrupt or mismanaged banks. This saves the wrong people (incompetent and corrupt bank managers and investors) and hurts the everyday investor or worker who watches his portfolio implode while the incompetent bank managers get to keep their jobs and big bonuses...
The trade war is back on. The trade deadline came and went at midnight last night without a deal. So 25% tariffs on $200 billion worth of Chinese goods took effect at 12:01. The tariffs had previously been set at 10%.
Based on Trump’s comments, 25% tariffs may possibly be applied to an additional $300 billion of Chinese goods.
China said it would respond with unspecified but “necessary countermeasures,” although negotiations continued today in Washington.
Some analysts say China can dump its large holdings of U.S. Treasuries on world markets. That would drive up U.S. interest rates as well as mortgage rates, damaging the U.S. housing market and possibly driving the U.S. economy into a recession. Analysts call this China’s “nuclear option.”
There’s only one problem.
The nuclear option is a dud. If China did sell some of their Treasuries, they would hurt themselves because any increase in interest rates would reduce the market value of what they have left.
Also, there are plenty of buyers around if China became a seller. Those Treasuries would be bought up by U.S. banks or even the Fed itself. If China pursued an extreme version of this Treasury dumping, the U.S. president could stop it with a single phone call to the Treasury.
That’s because the U.S. controls the digital ledger that records ownership of all Treasury securities. We could simply freeze the Chinese bond accounts in place and that would be the end of that.
So don’t worry when you hear about China dumping U.S. Treasuries. China is stuck with them. It has no nuclear option in the Treasury market.
How did we get here?
Trump’s trade representatives have complained that China had backtracked on previous agreements and that China was trying to renegotiate key points at the last minute. The Chinese are not accustomed to such resistance from U.S. officials. But Trump and his team are unlike previous administrations.
China assumed it was “business as usual” as it had been during the Clinton, Bush 43 and Obama administrations. China assumed it could pay lip service to trading relations and continue down its path of unfair trade practices and theft of intellectual property. Trump has proven them wrong.
Trump was never bluffing. He means business, which China is finally learning.
There’s still time to reach a deal, however, before the tariffs actually have any practical impact. The tariffs only apply to Chinese goods that leave port after last night’s deadline. That means goods already en route to the U.S. will not be affected...
The Federal Reserve is caught in a difficult situation of having to raise rates without causing another recession, said best-selling author Jim Rickards.
Unlike previous monetary cycles, the Fed is trying to raise rates in anticipation of a possible recession, even while the economy is not showing signs of overheating.
"The Fed is racing to get rates up to three and a half, four percent, wherever they can, before the next recession, even though the economy is weak. Normally, you would never raise rates in an economy that's as weak as we are right now but they're doing it anyway, because they're building up some capacity to cut rates in the next recession," Rickards told Kitco News.
Contrary to popular belief, the Fed's actions are reactionary to the economy, not prescriptive, and so is behind the curve on macroeconomic trends.
"The Fed never leads the economy. This notion that the Fed does things and the economy follows is not true. The Fed follows the economy, so they'll start out with coming out of a recession with very low rates and then unemployment will go down and inflation will tick up, capacity utilization will tick up, etc. and then the Fed watches and watches," he said.
Rickards said the last administration is to blame, as the Fed should have raised rates a little bit back in 2009, and not wait until 2015.
He added that the current Fed remains "patient" but may remove that word and change their dovish stance should the economy show more signs of growth.
