Clear And Present Danger

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by: The Heisenberg
Summary

The Mexico tariffs are "suspended", but the psychological damage is probably already done.

Calls for Fed cuts aren't likely to disappear just because the US won't be slapping punishing duties on imports from Mexico Monday.

That said, it's likely that rate cut expectations (as conveyed in certain popular STIR trades) have overshot.

Compared to historical instances where the market was pricing Fed cuts, the S&P is currently trading closer to record highs.

On Friday evening, the Trump administration announced that planned tariffs on all imports from Mexico are "suspended indefinitely".

After the president called off the tariffs, the State department posted a joint declaration on its website outlining a series of commitments. The New York Times would later report that two key pillars of the deal were in fact not new, but rather a rehashing of a pair of commitments Mexico already made to former DHS Secretary Kirstjen Nielsen. The president would later say the Times's story was misleading, but he did not substantively refute it on the merits. Meanwhile, three Mexican officials who spoke to Bloomberg on the condition of anonymity said increased purchases of US farm products were never discussed.

Why highlight the reporting from the Times and Bloomberg? Simple: It doesn't appear that there actually is a "deal" where that means an agreement that is materially different from existing arrangements. That, in turn, means the border crisis is highly unlikely to abate in a meaningful way, and that market participants will be fretting over renewed tariff threats against Mexico at some point in the future. Indeed, the wording President Trump used ("suspended") opens the door to just that. On Sunday morning, the president tweeted that if "for some unknown reason" things do not work out, America "can always go back to our previous, very profitable, position of tariffs."

Investors are encouraged to remember that while fears of what a worst-case tariff scenario on Mexico would mean (mechanically speaking) for the US economy were in part responsible for multiple Wall Street desks changing their Fed calls, rate cut predictions from the likes of JPMorgan, Barclays, Credit Suisse and BofA were also predicated on what the Mexico tariff threat conveyed about US trade policy.

Perhaps the best exposition on this point can be found buried in SocGen's Q3 economic outlook, in which the bank notes that "tariffs are being promoted as a kind of miracle cure for all possible issues that involve another country." SocGen goes on to warn as follows:

Imposing tariffs on a country with which the US has only recently concluded a trade agreement, sets a very negative precedent in that it suggests to other countries that even if they make concessions and conclude a trade agreement, the US administration apparently does not feel bound by it.

That does not bode well for negotiations with Europe around the prospective auto tariffs and it bodes poorer still for the resurrection of talks between Washington and Beijing. Incidentally, Goldman this week interviewed Michael Pillsbury, the man Trump has variously referred to as "the leading authority on China". In the exchange, Pillsbury makes a number of interesting observations about the hurdles to a trade deal. As regular readers can probably imagine, I am not personally inclined to be receptive to Pillsbury's view on China, but his comments to Goldman came across as fair, balanced and, in fact, well worth reading.

The upshot is that while some might be tempted to back off their rate cut calls in light of news that Trump isn't moving immediately forward with tariffs on Mexico, that's probably not a safe bet. Indeed, the first bank to weigh in on this point was Barclays, which on Friday pulled forward their call for 50 bp of cuts to July. Here is a short excerpt from the bank's take:

We continue to expect precautionary rate cuts from the Fed beginning in July. Downward revisions to our outlook for growth in US economic activity and expectations of 75bp in precautionary rate cuts this year from the Federal Reserve were not predicated on adverse direct effects from a major escalation in protectionism against Mexico; they were based primarily on incoming data on manufacturing production, business sector spending, durables orders, and capital goods imports that pointed to a more pronounced slump in goods production than we estimated previously. These data arrived in advance of the migration dispute. Our outlook did not include any negative direct effects from reduced trade flows or tariff-induced inflation in consumer prices. Following the May employment report, where employment growth was well below expectations, we shifted forward the timing of our Fed call modestly. We expect a 50bp rate reduction in July and a 25bp rate cut in September.

Other desks which have already penciled in cuts likely won't be deterred either. It goes without saying that these calls will only intensify if (or maybe "when" is better), the Mexico tariff threat comes back.

You're reminded that when the market is priced for cuts, it is rare that the Fed doesn't deliver. Consider this from Goldman, out Friday evening:

Since 1988, on 13 occasions the futures market expected a cut in the funds rate the day prior to a scheduled FOMC meeting. The Fed cut rates in all 13 instances. Futures prices currently imply an unchanged funds rate by the June 19th meeting. However, the market is pricing 20 bp of easing by the July 31st meeting, nearly 40 bp by the September 18th meeting, and 65 bp by the December 11th FOMC meeting. If the Fed does not intend to ease policy this year, history suggests it is likely to gradually walk back market expectations for easing in coming months rather than deliver a hawkish disappointment.

The bank goes further to document two instances in the past three decades when futures discounted cuts 30 days ahead of a scheduled FOMC meeting but the Fed didn't cut. You can read a bit more on that in "One Strategist Feels ‘Four Years Younger Today’, As Bad News Is Made Great Again", but for our purposes here, it's enough to note that the Fed is under tremendous pressure to deliver. At the very least, Jerome Powell will need to lay the groundwork at this month's meeting, or risk a selloff.

It's worth noting that what you're seeing in the rates market is likely a bit of a false optic, although with different drivers than the late March "Fata Morgana". That, in turn, may well mean that rate cut expectations aren't quite as acute as they appear. At least two readers on this platform have been "generous" enough this week to speak for the entire community by suggesting I not regale everybody with the finer points, but I imagine there are some readers who would prefer it if I raised key issues and let each individual reader decide for themselves what they're capable of understanding. In that regard, note that front-end pricing has likely overshot thanks to, as Nomura's Charlie McElligott wrote Friday, "extremely heavy-handed dealer short gamma hedging of legacy and massively popular low strike receivers and curve caps” and also thanks to an army of "renters" who have piled into popular STIR trades as a hedge against risk-off moves. These dynamics raise questions about what would happen to the rates trade in the event the president really is "playing 3D chess", as some folks are fond of suggesting.

In the same vein, if you compare the distance of the S&P (SPY) from record highs in 2019 to historical instances when Fed cuts were priced for the next 12 months, this year stands out. Here's Deutsche Bank's Steven Zeng, from a note dated Friday afternoon:

Examining only data points where rate cuts were priced until the Fed took action we find that the S&P 500 had traded entirely within 20% of its historical all-time highs when cuts were priced, and the bulk of the data were within 15% of the highs. Comparing now to the previous episodes, S&P is much closer to the record high. This suggests that either equities are discounting the downside risks more than in the past, or the current pricing of Fed cuts are too aggressive.

There is, of course, another interpretation, which Deutsche readily acknowledges. It's also possible that equity investors have come to believe the "insurance cut" story, where the Fed will step in preemptively due to the perception that a variety of factors have conspired to present a clear and present danger.

You could hardly blame investors for believing that. After all, the Fed has tried to restrike its "put" twice over the past 18 months (once in February 2018 and once in October) and while things turned out ok after the February 2018 drawdown, the October selloff morphed into a dangerous rout that looked poised to spill over into the real economy.

Don't forget that if you're measuring this tightening cycle by the rise off the lows in the shadow rate, the amount of tightening is actually north of 5%. Here's a panned-out visual to help you get a 30,000-foot view on this:

(SocGen)

And, below, find the breakdown relative to history:

(SocGen)

Although interpretations of this vary, it's plausible to argue that this is partially responsible for the market seemingly rebelling against further rate hikes in 2018 despite the fact that things still looked accommodative by comparison to history.

Again, these considerations are complicated by the trade outlook. I cannot stress enough how despairing some of the sellside commentary is with regard to US trade policy. The wielding of the tariff gun abruptly and at random to advance policy goals that are, at best, only tangentially related to economics, and have no plausible connection to trade more narrowly is, in fact, a clear and present danger for corporate America and thereby for the Fed.

It is impossible for corporate management teams to plan and invest in the current environment. It's just too fluid. Put yourself in the shoes of a CEO or a CFO of a major, publicly traded firm. Would you be comfortable budgeting capex years out in the current environment? Of course not. And your misgivings wouldn't necessarily have anything to do with your own political leanings or even with whether you did or didn't believe current policies will lead to positive outcomes 20 years down the road. Rather, you'd be frustrated because your experience in the business world has been rendered largely useless in the current environment due to the impossibility of predicting what the landscape will look like next week, let alone next year.

Obviously, this uncertainty is a factor in the Fed's decision calculus and it shouldn't be lost on you that this all comes very late in a cycle that is already long in the tooth.

In the same note cited above, Deutsche Bank underscores the notion that given the clear and multiplying risks, the Fed may feel compelled to step in sooner rather than later. The FOMC's decision in that regard may well determine whether 2020 (an election year) is characterized by the onset of recession and an equity market selloff or the opposite. I'll leave you with one last excerpt and chart from the bank's take (and remember, this analysis refers to returns relative to when the rates market begins to anticipate cuts, not to the cuts themselves):

Over the longer run, returns are mixed [after rates investors begin anticipating Fed cuts]. In 1998 the S&P was up strongly both 6 months and 12 months later. But in 2000 and 2006/2007 they were unambiguously negative, with the index down double-digits in both episodes. Fundamentals likely explained the different outcomes – in 1998 the US economy was able to sustain growth, while the other two instances it ended in recession. However, this shines a light on the comparisons made by several Fed officials this week to the 1995 and 1998 experience, and it perhaps argues in favor of the Fed making preemptive cuts sooner than later.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.