There is some debate as to the impact of recent tariffs, and whether the outcome would be positive or negative. This article illustrates how the Trump Administration used tariffs to solve trade imbalances, and address intellectual property theft, while controlling interest rates and preventing worldwide recession, all without raising inflation.
The Effect of U.S. Tariffs on Other Countries
Tariffs on Chinese goods had a dramatic effect on the Chinese economy in 2018 and 2019. As an example, their exports have fallen 3% and imports declined 5.2% in September compared to a year ago. Countries exporting to China, particularly Germany whose exports to the world account for 47% of its GDP, suffered the most from the downturn in China.
Germany’s Purchasing Managers Index (PMI) for manufacturing peaked at year-end 2017 at 65, and, as a result of their decline in their exports, declined in 2018 and 2019 to a low of 41. In reaction to the decline in German PMI, the Central Bank of Germany or Bundesbank reduced the 10-year bund yield from a positive 60 basis points to a negative 70 basis points by purchasing bunds and other assets from early 2018 to September 2019 (see Chart I).
The U.S., on the other hand, witnessed a strong 2018 with record-high PMI for manufacturing and a strong consumer economy. The Federal Reserve and the U.S. bond market reacted, as evidenced by the 10-year T-Note yield rising to 3.2% and Fed raising the federal funds rate to 2.50%, all while German yields declined (see Chart II).
Germany is the foremost country receiving the largest portion of U.S. manufactured goods. The sharp cutback in German imports from the U.S. in 2019, caused the U.S. PMI for manufacturing to decline sharply. The U.S. 10-year T-Note yield therefore peaked at year-end 2018 and dropped significantly from 3.2% to 1.47% on September 4th, 2019 due to both the decline in German bund yields and the huge fall in U.S. manufacturing PMI (see Chart II).
Successful Trade Negotiations Created the Low and Recovery in German Yields
The low in U.S. and German yields occurred in early September 2019. The 2-year German bund yield of -90 basis points matched its cycle low in early 2017. The reversal in the German 2-year yield was mirrored in the German 10-year upturn from -71 basis points (see Chart III).
By September 19th, the German 10-year yield rose from its low of -71 to -45 basis points and the German 2-year yield increased from -90 to -71 basis points. After pausing a month, German yields are rising above these breakout levels, as more trade agreements are reached (see Chart IV).
German T-Bill Yield Forecasts the Fed Funds Rate
The key elements to forecasting the federal funds rate are the German 3-month T-Bill and 2-year bund yields. In 2017, both reached lows of -90 basis points. By September 2019, the German 3-month low was -73 basis points, while the 2-year repeated the low of -90 basis points. During this 1 year 8-month period, the German 3-month yield recovered from below to above the 2-year yield (see Chart V). This reversal and significant increase in the German 3-month toward zero forecasts an end to negative German yields, and, therefore, a return to a positive yield curve.
Given a normal U.S-to-German yield spread of 170 basis points, and a positive 60 basis point 10-year bund yield, the U.S. 10-year T-Note yield is forecast to reach 2.30%. A federal funds rate decrease to 1.75% (expected in October) and possibly to 1.50% by 2020 would provide a 3-month T-Bill yield that is sufficiently low enough to ensure a positive U.S. yield curve (see Chart VI).
Tariffs established by the Trump administration created a chain of events that led to a positive outcome. The tariffs for China reduced manufacturing output in Germany and the amount of German exports to China and other countries. This in turn reduced German imports for the U.S. and U.S. PMI for manufacturing. Successful trade negotiations with Canada, Mexico, Korea and Japan, and potentially with China, allows the German economy to recover and for interest rates to return to positive levels. Given the sharp fall in U.S. T-Note yields and the inverted yield spread, the Federal Reserve must reduce the funds rate to the range of 1.75% to 1.50%. This reduction is a result of tariffs and successful trade negotiations imposed by the administration without increasing inflation. The decline in U.S. yields recycles the U.S. economy and reverses the economic slowdown.
It’s a win-win for the Trump administration.
Proof of this is the VFWIX, an index of all major foreign stock markets, excluding the U.S. Currently, this world-wide stock index does not forecast a recession, given the index keeps testing cycle highs of 20 to 20.5. A breakout above 20.5 would certainly forecast this win-win scenario (see Chart VII).
John E Rickmeier, CFA, President, firstname.lastname@example.org
Robin Rickmeier, Marketing Director