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 China’s economy in 2018 and 2019. Exports declined, as did consumer confidence, which impacted key discretionary spending, particularly spending on vehicles. China’s vehicle sales peaked at 3.06 million units a month at year-end 2017, then suddenly declined to 1.7 million units a month in early 2018. After recovering that year, monthly unit sales again dropped to 1.4 million in early 2019. These two dips in China’s vehicle sales shocked the world. China’s 12-month sum of vehicle sales in 2018 peaked at 29.5 million units and fell to 26 million as of September 20191 (see Chart I). By comparison, U.S. and Europe annual sales remained stable at approximately 17 million and 11 million, respectively2. 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, fell to a low of 41 in 2019. 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 II).
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 III).
Germany is the foremost country receiving the largest portion of U.S. manufactured goods. The sharp cutback in German imports from the U.S., caused the U.S. PMI for manufacturing to decline sharply in 2019. The U.S. 10-year T-Note yield, therefore, peaked at year-end 2018 and dropped significantly from 3.2% to 1.47% by September 4th, 2019 due to both the decline in German bund yields and the huge fall in U.S. manufacturing PMI (see Chart III).
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 to a recent high of -34 basis points (see Chart IV).
By October, the German 10-year yield rose from its low of -71 to -34 basis points and the German 2-year yield increased from -90 to -64 basis points. (see Chart V).
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 VI). This reversal and significant increase in the German 3-month toward zero would forecast 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%. The Federal Reserve reduced the funds rate to a range of 1.75% to 1.50% in October. This provides a 3-month T-Bill yield that is sufficiently low enough to ensure a positive U.S. yield curve (see Chart VII).
Tariffs established by the Trump administration created a chain of events that led to a positive outcome. The tariffs on China decreased discretionary spending, particularly in vehicle sales. This reduced the amount of German exports to China and resulted in a decline in German PMI. This in turn caused a decline in German imports from the U.S. and resulted in a dramatic decline in the U.S. PMI for manufacturing. All this having the effect of reduced interest rates worldwide.
Successful trade negotiations with Canada, Mexico, Korea and Japan, and potentially with China, allows China’s vehicle sales and German and U.S. economies to recover. Given the sharp fall in U.S. T-Note yields and the inverted yield spread, the Federal Reserve reduced the funds rate. This reduction in U.S. yields and a return to a positive yield curve 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.
Additionally, China’s September vehicle sales were at 2.3 million units, an annual rate of 27.6 million, above the 12-month moving average of 26 million units; China’s vehicle sales are now in recovery (see Chart I).
Proof of all 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 20.4. A breakout above 20.4 would certainly forecast the win-win scenario of a positive resolution to trade negotiations and renewed expansion in the world-wide economy (see Chart VIII).
John E Rickmeier, CFA, President, email@example.com
Robin Rickmeier, Marketing Director