Source: WSJ

Just back from ranting about this on CNBC so I’ll quickly share some thoughts on the news that the Chinese yuan broke 7/$, in a depreciation that threatens trade-war escalation.

Bottom line: the trade war may be about to get worse, and that won’t be good for markets, consumers, and the global economy. It’s hard to see a way out between these two sides, though electoral politics could force Trump to stand down next year.

The numbers:

–Depreciations offset tariffs. That is, a 10% tariff, paid by importers and passed forward to consumers, is fully offset by a 10% depreciation. This is especially relevant in the case of Trump’s latest plan to place a 10% tariff on $300 billion more in Chinese goods, two-thirds of which are consumer goods (shoes, apparel, toys, cell phones). Earlier tranches have mostly been intermediate goods.

–The yuan depreciated over 1% relative to the dollar since last night and about 13% since its peak in March of 2018 (see figure above).

–Markets, which have been highly sensitive to the ups and downs of the Trump/China trade war, ain’t loving this; Dow futures are down about 300 points prior to today’s opening.

–If the market’s trade-related losses (which began last week) continue, it raises the question of the extent to which worsening financial conditions counteract the impact of last week’s Fed rate cut, and thus raises the likelihood of further cuts.

The trade politics:

–What’s freaking out the markets is their expectation that Team Trump will view this as an escalation. In fact, China’s central bank said the move was “due to the effects of unilateralist and trade-protectionist measures and the expectations for tariffs against China.”

–I share the market’s expectation. Trump obviously has more weighty, tragic issues to deal with today, but one thing he seems to understand is the role of currency movements in this fight and I expect him to hit back.

–The most obvious response would be to raise the 10% on the $300bn to match the 25% already in place on the rest of our imports from China.

–These dynamics aren’t pretty for China either. They have to worry about the impact of the devaluation on capital flight, an increasing problem in China. Also, since many Chinese firms borrow in dollars, this makes their debt service more expensive.

–Meanwhile, the whole damn trade war looks to be going badly from Trump’s perspective, predictably so as such wars tend to ding both imports and exports. In fact, in the most recent quarter, exports/GDP were close to a 10-year low and the trade deficit hasn’t improved at all on Trump’s watch.

–Is there any way out of this mess? The only thing I can think of is a political pressure valve. If the escalating trade war whacks US consumers through inflation and real growth channels, and does so close enough to the 2020 election, Trump could decide to dial his protectionism way back, and fast.

–As noted, markets are highly elastic to such whipsawing, and businesses have probably held back investments as well due to trade-war-induced uncertainty. So, the economic impact of some sort of resolution could be quite positive.

–Analysts at Goldman Sachs made an interesting point about this possibility. Suppose the Fed lowers more aggressively to offset any forthcoming escalation. Then, for electoral reasons, Trump suspends the war. The Fed will be reluctant to raise much in an election year, so GS argues this could pose an overheating threat.

–I’m inherently skeptical of arguments with a lot of links in their chain, and predictions of overheating have consistently been wrong. But worth watching.