Why a U.S. Tariff Plan Could Backfire

Wharton's Jeremy Siegel and Fordham's Matt Gold discuss the implications of Trump's proposed tariff plan.

steel mill

President Trump’s announcement last week that his administration would levy import tariffs on steel and aluminum to protect those industries in the U.S. has stoked wide-ranging fears. His plan is to impose import duties of 25% on steel and 10% on aluminum. The Dow Jones and the S&P indices reacted strongly, shedding 3% and 2%, respectively, over four successive trading days, before recovering somewhat on Monday.

Trump’s tariff plan is flawed on several fronts, according to experts at Wharton and Fordham University. Trump’s objective to protect the fortunes of U.S. steel and aluminum makers will end up raising prices for those products and hurt all sectors that use them, notably the automobile and energy industries. That, in turn, will depress the stock markets, whose upward climb he has taken credit for, said Wharton finance professor Jeremy Siegel.

The Trump tariff plan would also run afoul of international trade agreements and U.S. compliance with the World Trade Organization’s rules, said Matt Gold, adjunct law professor at Fordham University. Gold was formerly deputy assistant U.S. trade representative for North America. He added that the latest policies on steel and aluminum imports have the support of White House officials with potential conflicts of interest – they have had business dealings with companies in those industries.
‘Severe’ implications, loss of credibility

“This is anything from bad to a complete train wreck,” said Gold. “The implications are potentially very significant and very severe at a minimum.” The tariffs would raise prices of goods and services across the board in the U.S. and undermine the country’s credibility in the global trading system, he added. The tariffs would not just increase prices for all users of steel and aluminum, but also lead to job casualties, Siegel noted. “You’re going to lose auto jobs to gain steel jobs.”

The retaliatory action to U.S. tariffs may not be swift, but it will hit hard. “A bunch of trading partners – the big ones – will take us to court or litigate,” said Gold, adding that it might be a few years before they get the legal authority to retaliate against the U.S. “The retaliation they’ll be authorized to commit will be so severe we’ll have to take away the duties immediately if we haven’t at that time,” he noted. China, Canada and Brazil are among those countries expected to levy retaliatory duties on imports from the U.S., according to media reports.

At the same time, many countries could raise trade barriers against imports from the U.S., according to Gold. “The U.S. government is making an argument that [the steel and aluminum tariffs] qualify as an emergency in international relations and a national security emergency,” he said. “Other countries could argue they have the same exact kind of emergency that would allow them to block U.S. agriculture.”
Gold pointed out that the U.S. is “the world’s foundational economy” and the chief architect of WTO agreements, and a willful violation of those rules “undermines the entire system…. We’re risking a global trade war.”

Siegel did not think a trade war is imminent, but at the same time, he noted that “the risks are not zero.” He likened Trump’s move to the Smoot-Hawley tariff of 1930 that raised U.S. duties on more than 20,000 imported goods. “A trade war is implanted in many Republicans’ minds as a major cause of the Great Depression,” he said. “So Trump is going to have a much harder time implementing this unilaterally without Republican acquiescence, which I don’t think is going to be there.”

Siegel also thought Trump’s move could have wider ramifications. “[It] is not a slam dunk that this cannot escalate into something much worse,” he said. He explained how the fallout could get uglier beyond current expectations. “The biggest threat to the market this year is still going to be rising interest rates,” he noted. “But if this [tariff plan] blows up into something big, it will be a much bigger threat.” He pointed out also its political ramifications, with mid-term elections in November to the House of Representatives and the Senate. “Republicans are [facing] very serious problems with retaining the House of Representatives,” he said. “So there’s going to be much more pushback by the Republicans on this.” 
Wall Street Not Amused

Not surprisingly, Trump’s tariff announcement hasn’t played well on Wall Street. “This was always the part of Trump that the market never liked,” said Siegel. He recalled that before the presidential election, “the markets seemed to have a clear preference for Clinton over Trump – and it was mainly fear of trade, tariffs, restrictions, quotas, barriers and whatever.” But once Trump was elected, the markets rejoiced in the prospect of tax cuts, which Trump signed into law in December.

The markets “hoped [Trump] would forget about his other part of his agenda,” which was to adopt protectionist policies that would prove counterproductive and hurt U.S. industries and jobs, said Siegel. “Well, he seems to now have remembered the other part of the agenda.”

The stock markets recouped some lost ground on Monday after Trump tweeted that his proposed tariffs “would only come off if a new and fair NAFTA (North American Free Trade Agreement) agreement is signed” with Mexico and Canada, and demanded that Mexico “do much more on stopping drugs from pouring into the U.S.” 
Not Exactly a Party Mood

Siegel noted several disconnects between Trump’s ideas and the Republican Party and even the White House bureaucracy. “There’s the Republican agenda for the economy, which is good for the stock market, and [Trump is] an enabler of that,” he said. “Then there’s the Trump agenda that differs from the Republican agenda – [on issues such as] trade restrictions and the immigrant restrictions, [which] the market does not like.” In that setting, Trump is sure to get pushback from not just the Republicans, but also the White House and the general public, he added. He also found as “ludicrous” Trump’s comment that the tariffs would enhance national security.

According to a report in the Financial Times newspaper, “The president’s decision came after a chaotic 24 hours in which pro-trade forces in the White House led by Gary Cohn, head of the National Economic Council, fought back against plans to announce tariffs, according to people familiar with the discussions.”

Republicans would be particularly touchy about the kind of tariffs Trump has proposed, and Gold put that in perspective. “It wasn’t just that the Smoot-Hawley tariffs, [which were] implemented by a Republican president and a Republican House and Senate after the crash in 1929, was the major cause of the Great Depression,” he said. “It was that it sparked a trade war which sent the European economy into a downward spiral far worse than the Great Depression here [in the U.S]. Banks failed. Currencies were worthless. And an obscure political party in Germany which had no traction for 10 years – the Nazi party – suddenly came to power. It’s considered the largest single cause of the Second World War.”

Cut to today, and the consequences could be far worse, Gold warned. “The potential catastrophe of a trade war goes way beyond a Depression, especially because what collapsed the economy of Europe in the early 1930s today would collapse the global economy instantly at the speed of electricity,” he said. “You couldn’t have one continent collapsing in isolated fashion.”

Gold also pointed to potential conflicts of interests behind the tariff plan. “Supporting this inside the White House is Wilbur Ross, the secretary of commerce, who made his fortune in the steel sector, U.S. Trade Representative Robert Lighthizer who had a significant number of steel and aluminum clients when he practiced law for decades … and Peter Navarro (advisor to Trump and director of the White House National Trade Council).”

When Tariffs Make Sense

Import duties are justifiable in specific circumstances, and Gold explained those. In January, the Trump administration imposed “safeguard duties” on imports of solar panels, arguing that Chinese companies were dumping them. Last November, it imposed anti-dumping duties on imports of Canadian lumber, citing similar concerns. Safeguard duties, antidumping and countervailing duties are legal under the WTO law so long as they comply with the governing U.S. statutes because in most cases the two are similar, said Gold.

“What collapsed the economy of Europe in the early 1930s today would collapse the global economy instantly at the speed of electricity.” –Matt Gold

But the situation would be different if the U.S. cites threats to national security as a reason to impose import tariffs. The threshold to justify that is much lower under U.S. statute than it is under international law, Gold explained. That is how the U.S. would find itself as a violator of WTO rules, he explained.

Tariffs of the type Trump has proposed are imposed on countries even if they have a free trade agreement between them, Gold said. Only ordinary customs duties get eliminated by free trade agreements, and not special duties like anti-dumping duties, countervailing duties or national security duties, he explained.

Even as the NAFTA link to Trump’s tariff plan is tenuous, Canada happens to be the biggest exporter of steel and of aluminum to the U.S., according to Gold. “The Canadians are beside themselves for reasons that are not surprising,” he said. He noted that the NAFTA negotiations “were struggling anyway” and would probably be put off for a year in view of the elections in Mexico in July and the U.S. midterm elections in November.

According to Gold, as a party to the WTO, the U.S. has obligations that prevent it from imposing the types of duties Trump has proposed. It could, however, press ahead if it is able to justify the tariffs on the grounds of threats to national security. But that would be in conditions where the country is at war or in an emergency situation, which is not the case now. “The long and the short of it is that he’s violating international law,” Gold said. “But under the U.S. statute in this situation, he had to have at least a national security justification.”

While announcing his tariff plan last Thursday at the White House, Trump told representatives of steel and aluminum companies: “We have to get this done … for your company and for your workers and for so much else, even the security of our own nation…. You will have protection for the first time in a long while, and you’re going to re-grow your industries.” 
“[Trump is] validating myths that his constituency believes – myths about an economy past that no longer exists … in certain places and certain sectors, and myths about what imports do and what trade agreements do and how they hurt different parts of the U.S. economy,” said Gold.

In any event, Trump may be acting a little too late in trying to protect steel and aluminum jobs, according to Siegel. “The workforce has greatly adjusted already to that,” he said. “It’s sort of a time past – the adjustment is made, the jobs have been lost.” He also noted that the U.S. manufacturing sector has been adding about 10,000 jobs monthly, which is just 5% of the roughly 200,000 new jobs.

Eventually, Trump may need to take a cautious approach to his tariff plan, said Siegel. “Here is a president who’s very proud of the fact that the stock market has done very well over his tenure,” he noted. “If the market starts tanking because of these policies, it doesn’t look good for him.” That factor might compel him to reconsider his moves, especially since “whatever positive he has in the polls is due partly to the good markets and the continuation of a good economy.” All said, will he press ahead with his plan? “Trump has made a lot of threats and doesn’t carry through with them,” said Siegel.

The Federal Reserve's Perfect Unwind


The Federal Reserve is now hacking its own zombie recovery to death and eating it by reversing the actions it employed to create this artificially supported recovery. Each time the Fed unwinds its balance sheet, 10-year bond rates recoil, and the stock market dances along in countermoves and wild swings. 

Blinded by economic denial because they are evangelists to the Fed’s religion, market pundits are finding any rationale they can to avoid connecting the Fed’s Great Unwind with these huge swings in long-term interest rates and the obviously corresponding counter-swings of the stock market. For those who have eyes to see, however, it should be clear that the world’s largest bond and stock markets are shuddering as the supports are removed.

Proving he’s the king of hacked and bloody baloney, Larry Kudlow contrived the following alternative rationale for the stock market’s recent sell-off earlier this month:

The stock market’s big sell-off last week, coming after a weak dollar and rising gold and commodity prices, may well have stirred inflation fears and higher bond yields. (Newsmax)

What an ambitious attempt to cover the obvious cracks that are already opening up in the economy due, in part, to Larry’s lame tax plan. That plan is now acting as an accelerant to the burn created by the Fed’s moves to raise long-term interest rates. (You no doubt recall that the Fed bought long-term government bonds in order to drive down long-term interest rates; so, of course selling off those bonds will drive interest rates back up.)

Larry believes he can rewrite history on the fly by pretending the stock market sell-off preceded and, therefore, caused the rise in bond yields. He flaunts that argument in the face of the fact that bond interest shot up first and then the stock market took its nosedive in a panicked response. Larry had to scribble out a alternate narrative in order to throw a little dirt over the sudden cracks that started to form after congress’s approval of the tax plan, which he huuugely helped create. Larry would prefer for you to believe the stock market fell due to rising gold and commodity prices and a weak dollar, which he claims also caused the bond market sell-off.

“Nothing to look at here in the debt-dependent tax plan, Folks; move along.” Yeah, just ignore the conspicuous elephant in the room, which is that the largest dumping of government bonds in the history of the world coupled with the most debt-dependent tax plan ever concocted has to drive up interest rates on government bonds. There are no economic forces strong enough to counter that combination.

Deny also that a rise in long-term bond interest is going to be detrimental to stocks as Mohamed El-Erian did in response to the stock market’s nosedive. You would think the bond king, of all people, could see something as obvious as that; yet, El-Erian seized the day of the market’s collapse to rhapsodize the beginning of Fed’s Great Unwind from its years of quantitative easing:

The favorable recent experience of the Fed — specifically, the orderly halt of its asset purchases, raising rates several times, getting the market ready for three more hikes in 2017, and putting forward a plan for balance-sheet reduction — shows that a “beautiful normalization” is possible for the most powerful and influential central bank in the world. (NewsMax)

The second the Fed notched its balance-reduction efforts up to $20 billion a month, bond yields flew into a tantrum equal to the taper tantrum that happened back when the Fed merely announced its plan for the “orderly halt of its asset purchases” back in 2013. (That earlier event all by itself was enough for any intelligent person to know in advance what would happen when the Fed started to actually reverse those asset purchases.)

So, mentioning the end of the plan caused a tantrum, and actually reversing the plan by unwinding the balance sheet caused a tantrum. Yet, most market gurus still miss the obvious connection between the unwind and the rise in interest. I don’t know how you can miss the obvious tremors that happen every time there is serious talk or action regarding the backing off of QE. or how you can call an immediate plunge in the stock market greater than any single-day point drop in its history (twice in about a one-weak period) a “favorable recent experience.”

El-Erian must have spent the previous night smoking opium. His comment is unfathomably blind. It has to involve some form of psychological denial. Perhaps the fact that the Fed’s Great Unwind will, in fact, unwind the entire economy would raise an apocalyptic level of fear in some people if they faced the present evidence that it is already happening. (I call it “economic denial,” which has reigned supreme all over the world for as long as people have been willing to pretend that mountains of national debt are completely irrelevant and that they will not harm the next generation.)

If one doesn’t believe that is even possible for the Great Unwind to raise interest rates (even though the whole purpose of QE was ostensibly to lower interest rates), then they look at the stock market’s obvious response to those interest rates, deny the rates are the cause of the market’s tumble and then call the Fed’s unwind “beautiful normalization.” (Have you all seen how beautiful the emperor’s new clothes are?) As an alternative explanation to El-Erian’s brain-bending analysis, maybe the emperor of bonds just has a lot of bonds of his own to dump before he starts speaking truth.

The inflation ruse

You need alternate explanations in order to ward off unwanted truth. One script being written by some analysts right now is that the stock market’s sudden fibrillation was solely due to inflation shock and is not about the Fed’s Great Unwind at all. (Never mind that even a former Fed governor attributed the market turmoil to the coinciding event of the Fed’s first serious roll-off of government bonds from its balance sheet.)

The explanation is pinned to the belief that the only factor that influences bond interest is inflation predictions. Naturally, inflation forces bond interest to rise in order to attract investors because bonds are held long-term. Therefore, they have to compensate for inflation for the duration of time the investor’s money is tied up in the bond. While that is one dynamic of price discovery in a functioning bond market, it is far from the only dynamic. After all, the Fed stated quite clearly that it was buying hoards of US bonds in order to drive down long-term interest by sucking up the supply of bonds (which also assured the US government’s interest on its monstrous debt would remain uncommonly low.)

Even if it were true that concern over inflation was the only thing that drove up bond interest, the fact would remain that the stock market fell because of concerns about interest rates. Inflation would only have been a concern because it was driving up interest. So, the argument that the market’s fall was all about inflation, short in truth as it is, doesn’t get you very far.

However, the notion that bond interest only moves in response to inflation concerns is easily proven wrong: after the last economic crisis, hordes of investors around the world purchased bonds that, after inflation, offered real negative interest rates just because fear drove the purchase of bonds as a refuge.

The attitude of investors was “Inflation be damned; all I care about is security.” People were willing to take a guaranteed loss of money to inflation just because that was seen as a smaller risk at the time than the risks of the stock market.

The Wage Scare

The notion expressed by El-Erian that the Fed is halting its asset purchases in an orderly way is as nutty as Almond Roca. There was nothing orderly about the movement of stocks in late January and throughout February. Yet, there are many analysts who so fully believe the Fed can unwind its mass wholesale purchases of bonds that many commentators blamed the market’s mayhem on a minor blip in hourly earnings (again, because higher wages would presumably cause inflation):

The inflation bogeyman has reared its ugly head and sent U.S. stock investors racing for the hills in recent days. Next week, coming off one of the most volatile stretches in years, two important readings on U.S. inflation could help determine whether the stock market begins to settle or if another bout of volatility is in store….

The equity market has become highly sensitive to inflation this month. A selloff in U.S. stocks earlier this week was in large part sparked by the Feb. 2 monthly U.S. employment report which showed the largest year-on-year increase in average hourly earnings since June 2009. (Newsmax)

Here you have to believe that the hint of a problem (raises in wages) about the hint of a problem (inflation) caused the market to completely lose its head. The argument written above is circular thinking anyway. The idea is that the market went down because concerns about inflation would cause the Fed to do more interest hikes. Well, in that case, what the markets are really concerned about still comes back to interest rates! So, stop pretending interest doesn’t matter. The bottom line is that investors are scared to death of the tiniest lift in interest because we are buried in mountains of personal, corporate, and federal debt that are completely unsustainable as soon as interest rises from the artificially low levels that were maintained by Fed purchases of government bonds.

Debt is of Great Interest Now

Bond yields are not at a level that should alarm anyone if the economy is truly healthy and if $20 trillion of federal debt is not that important or if the level of personal debt in the nation is not lethally high. Yet, the market has just shown itself to be highly reactive to a minute move in long-term interest. So why is the market so overwrought about a uptick in long-term yields?

Even the rate at which interest is rising reveals something:

“The pace really does matter,” said Ron Temple, Head of US Equities … at Lazard Asset Management in New York. “If we see 3.0 percent next week that is going to spook people more – the equity market psyche is fragile at this point….” The fragile investor psyche is likely to lead to continued volatility.

Why so fragile since “the economy is great” is the mantra everywhere? Why spooked by a 3 percent yield when the average level for the ten-year treasury bond over the past three decades is 4.83 percent — two points higher than where it is now?

“Psyches” are often concerned by deep troubles that people don’t understand or see. “The fragile investor psyche” right now is responding in knee-jerk fashion to small moves to historically low levels of interest. Might that not have something to do with the fact that trillion-dollar deficits appear to be the permanent norm at a time when we face the biggest bond dumps in history? (And, yet, people argue with me and claim there is no foreseeable trouble ahead. Ahead? It’s already showing up!)

The national debt has already increased by $416 billion in fiscal year 2018, and we’re not even five full months into the year. At the current rate of growth, that equates to an FY [fiscal year] 2018 increase of just over $1 trillion. The deficit for FY 2019 is expected by many budget analysts to be around $1.2 trillion…. In June, CBO estimated that the national debt would be $21.221 trillion at the end of FY 2018, a sum that looks like it will be easily exceeded.

By the end of FY 2021 the debt was expected to be $23.878 trillion, a figure that now looks like it will actually be closer to $25 trillion or more…. Making things worse is the interest expense on all that debt. In FY 2017 the federal government spent $458 billion on interest on the national debt. As the debt increases, that sum will increase. And as interest rates continue to increase, that sum will increase even more. The current average interest rate on federal debt is just over 2 percent. In 2005 it was closer to 4 percent, and in 2001 it was over 6.5 percent. (Newsmax)

These facts are so enormous and so obvious that it boggles the mind that so many investment gurus and their clients can so easily ignore them.

Tagging the recent tantrum to government policies, Charlie Mcelligott of Nomura Capital Investment Co. writes,

In hindsight, the ‘tie-breaker’ which drove UST 10Y yields out of their multi-month 2.35-2.50 range into this new stratosphere looks to have been the US fiscal stimulus / tax reform plan passing the initial Senate vote on December 2nd, 2017. By December 6th, the UST 10Y Term Premium had inflected from 1+ year lows … and “hasn’t looked back…. Point here being that the uber-ambiguous “something has changed in the market” meme … is based-upon the underlying change in perception with regard to a bond market that is waking from its slumber due to a new-found Central Bank willingness to normalize policy…. (Zero Hedge)

There it is; two things: the government’s tax plan and the central banks plan to unwind quantitative easing. Nomura’s head of Cross-Asset Strategy, however, goes on to state that the Fed’s normalization will happen due to concerns about inflation and too much growth due to congress’s tax cuts and fiscal stimulus, but that ignores the fact that the Fed’s normalization trajectory (of its interest targets and its balance sheet) was clearly laid out long before congress hatched a tax plan and way back when inflation refused to move (at least, as far as the way the Fed reads inflation).

The fact is interest rates spiked up the most just as the Fed’s normalization began its prescheduled ramp-up at the end of January. The market is sensing subconsciously (apparently not consciously since few are talking about it) that we have just entered a time unlike any in human history: 1) The Fed is starting to suck money off its balance sheet and out of the economy at an order of magnitude far above anything ever seen; so, 2) it is backing away from funding the federal government just as the federal government is creating massive expansion of its financing. If the Fed succeeds in unwinding quantitative easing, it will be a global first.

Here is a graph by Lance Roberts that shows where the national debt was in relation to our ability to pay it before all of congress’s latest increases to the deficit:

(Click to enlarge)

The debt is now $2 trillion higher than in that graph, and its rate of growth has gone more sharply upward (after the cut-off date of the graph) under Republicans. You can see we crossed the debt Rubicon at the start of the Great Recession with no end in site.

Don’t think we are going to beautifully grow our way out of it. As you can see from the graph, GDP would have rise to a level never seen in order to match back up to our government’s debt (even if the debt stopped going up, but the debt is now rising astronomically). Moreover, the last time corporate tax rates were cut from 50 percent to 35 percent, the five-year average for the GDP growth rate fell across all of the following years, and the last time capital gains taxes were cut, the five-year average for GDP growth rate fell across all of the following years, too.

Lest you think this time will be different, do you remember that huge burst of GDP growth in the Atlanta Fed’s forecast at the start of February, which put the US on track for first-quarter GDP growth of a whopping 5.4 percent? (Trump be trumpeted!) That was just revised down by fifty percent to the same routine 2.6 percent that has plagued us throughout the aftermath of the Great Recession. Well, that hope was short-lived.

So, GDP is not going to see any meaningful rise and may even fall as it has in the past. That is because the rise in debt consumes the potential for growth that could come from tax reductions when spending is not cut correspondingly. That problem is hugely exacerbated when government spending is increased as taxes are cut. Congress is acting in a fool’s paradise.

With each of those major past tax reductions, GDP continued to grow, but at a slower rate than in the years before the cut. While the cut in capital gains taxes gave a slight bump up in the rate of growth for a few years, the overall trend at the lower tax rate went down in all the years after that initial bump. And don’t let any jump in revenue in 2018 confuse you. A jump could happen this year as massive amounts of overseas profits get repatriated this year, but that is a one-off.

By the end of this decade the US national debt will be greater than the combined national debts of all the other nations on earth! And that is why markets are so reactive to any change in government bond interest.

What Goes Down Must Come Up

It is absurd to think you can reverse an action that caused the stock market to rise (by intention) and not cause it to fall!

The very fact that so many analysts are saying the market had a tantrum over mere HINTS of inflation, shows that the coming bond-interest problem is not priced into the market yet. (Given that any concern in stocks about inflation is really about how inflation drives interest rates.)

How can rising interest be priced in when the problem is being denied by, at least, half of the analysts/commentators that I’ve read in the past week, particularly those from large banks and other large firms? You cannot price in any factor when you deny its very existence as a problem.

Heck, the former head of all banking denied even the possibility of a problem:

U.S. Federal Reserve Chair Janet Yellen said that she does not believe that there will be another financial crisis for at least as long as she lives, thanks largely to reforms of the banking system since the 2007-09 crash. (Newsmax)

From what I’ve seen, financial crises have happened about every decade. Maybe, Yellen’s planning on a short life because she’s getting up there. Let me note that overconfidence has never created security, but it has certainly caused insecurity and collapse.

Proving the Lie that is all about Inflation

In mid February, following the market’s big plunge, inflation rose more than it has in years, and the stock market barely flinched. In fact, after a little dip, it gave a Valentine’s Day treat to investors with a tidy rise. Just maybe that was because bond rates did not respond as quickly to this astronomical (on a monthly basis) rise in inflation as they did to the Fed’s end-of-January upshift in balance-sheet reduction.

That belies the whole argument that the markets are concerned most with inflation. On an annualized basis, the inflation rate that the Fed bases its interest targets on (CPI) rose to 6.7 percent in January! If that rate held as a new trend in the months to come, it would be the worst inflation we’ve seen in three decades. It’s ludicrous to argue that the market fell because a hint of an uptick in wages, which in turn hinted at future inflation when the market subsequently rose upon news of massive actual inflation data. You can’t play it both ways.

In fact, year-on-year, wages also rose in tandem with CPI that day (2.4 percent for wages and 2.1 percent for CPI), both of which had been the predominant explanations for the stock market’s previous drastic plunge. Yet, the stock market rose. When reports on inflation and wages showed both to have risen in tandem the most in years, the market rose! So, the narrative that the market fell due to rising wages and inflation concerns is … well, baloney.

Even the harmonious occasion of inflation, wages and stocks all rising merrily together didn’t stop the relentless denial. Danielle DiMartino Booth of Bloomberg View wrote,

With all the attention focused on the stock market drama last week, it’s understandable that new inflation data got lost in the shuffle. But let’s not forget that rising prices are what woke the bond market from its long slumber in the first place. (Newsmax)

Yeah, that’s what happened: it got lost! So big was the initial concern about inflation that a mere hint ended the long Trump Rally, and yet when much bigger REAL numbers came out, the market whistled blithely past the graveyard. Sure. It only seems as though concern about inflation “got lost” when you wrongly presume that was a concern in the first place.

The denial continued as late as February 22nd when Marketwatch published an article titled “Too many stock-market pundits are wrongly freaking out about inflation” in which they wrote,

Wall Street went nuts when signs of inflation appeared in two government reports. In January, average hourly earnings rose at a 2.9 percent annual rate and the consumer-price index increased by a higher than expected 0.5 percent. That was enough to send the Dow Jones Industrial Average DJIA, +0.57 percent and the S&P 500 index SPX, +0.65 percent to their first official 10 percent corrections in two years, while the CBOE Volatility index (the VIX VIX, -12.43 percent ), Wall Street’s fear gauge, shot up into the high 30s. Investors worried that the specter of inflation would prompt the Federal Reserve to raise interest rates more aggressively, which would be anathema to stocks. I believe these fears are way premature.

They might be premature if that was their fear, but it wasn’t.

Even when they see that long-term bond interest is clearly involved in the dynamics, they still revert to thinking it is all about inflation:

U.S. stocks ended a volatile session on a downbeat note on Wednesday, as an afternoon rally quickly fizzled in the wake of the Federal Reserve releasing the minutes to its most recent meeting. The Dow Jones Industrial Average … fell 168 points … as investors struggled to digest the minutes, which pointed to a strong economy, but also the “increased likelihood” of more rate hikes ahead. The news pushed the U.S. dollar higher and sent the yields for the 10-year Treasury note to a four-year high of 2.95 percent. Recent trading on Wall Street has been driven by the prospect of inflation returning to the economy, and the Fed having to become more aggressive in raising rates to combat such a scenario. (Marketwatch)

It’s really all about interest rates making the national debt and a vast number of other debts impossible to maintain. Another article by Marketwatch on Wednesday came a little closer to the point:

A deflation of the brisker buying sentiment in stocks … was attributed partly to a climb in yields for the 10-year Treasury note to a session high, and a four-year peak, at 2.95 percent.

(My emphasis, as they really don’t want to go there because of the conclusions it leads to.)
Economist David Rosenberg also noted,

“This isn’t about inflation. If it were, TIPS break-evens would be sitting far higher than 205 basis points,” Rosenberg said in a Feb. 12 report, referring to Treasury inflation-protection securities. “Oil wouldn’t have collapsed 10 percent last week…. This fixation on the 2.9 percent wage growth figure that came out with the January payroll report is ridiculous considering that the average hourly earnings number for production and non-supervisory workers (over 80 percent of the workforce) barely rose last month and the year-over-year showed no acceleration at all – it stayed at 2.4 percent,” (Newsmax)

Rosenberg also rightly notes that the major accelerant for the market’s burn was the lack of liquidity in exchange-traded funds (ETFs), many of which have large holdings of bonds.

Rosenberg chided The Wall Street Journal editorial page for its economic cheerleading, including the statement that “the good news is that U.S. economic fundamentals are as strong as they have been since 2005, and maybe 1999.” “Good grief … in 2005, we were heading towards the most pernicious housing bubble in history and in 1999 we were moving rapidly towards a massive tech bubble. Nice comparisons…. This isn’t about ‘fundamentals.’ This isn’t about inflation – in fact, this is the weakest argument of them all in terms of explaining what is going on in markets,” Rosenberg said.

“The 1987 crash was not about inflation. The 1998 correction was not about inflation. The start of the bear market in 2007 was not about inflation.”

While Rosenberg focuses on liquidity as the problem, I would say liquidity was just the accelerant.

The market did not fall because of concern about liquidity; it fell because of concern about bond interest, and lack of liquidity exacerbated that fall.

As for the idea that concern over the Fed’s notes about interest-rate increases stemmed from concerns over inflation, the Fed’s notes that the market was ostensibly responding to said nothing about stepping up the pace for interest-rate increases but only indicated the Fed would maintain its course of “further gradual increases.” It’s highly unlikely that “maintaining the course” caused the market to fall.

Yet another chance to understand the dynamics at work came when long-term interest shot up again last week in response to the Fed’s minutes stating the Fed would maintain its path of rate increases.

The 10-year yield rose nearly to that 3.0 percent critical mark I’ve talked about. The reappearance of such sensitivity in long-term interest caused the stock market to shiver again last week, too, breaking its recent rally.

After interest relaxed a little, stocks and bonds repeated their inverse dance this week when interest on the 10-year treasury bond shot back up immediately to nearly 3 percent and the stock market fell 300 points because the new Fed chair, Jerome Powell, spoke to the House of Representative’s Financial Services Committee in his public debut about the strengthening of the economy.

Stocks and bonds have finally reverted to their historic norm of stocks falling when bond yields rise.

Yields rose because the Fed Head’s words emphasized that the Fed fully intends to press forward with its plans to raise interest rates and unwind its balance sheet, given the apparent strength of the economy.

I can only see denial (maybe due to subconscious fear of something so dangerous) as an explanation for how people can miss the obvious fact that interest is extraordinarily sensitive right now and tied to each and every drop in the stock market. That sensitivity never showed up until the end of January when the Fed finally doubled down on its balance-sheet reduction after three months of not living up to its promises. Let me refer to something written by Keven Muir of the Macro Tourist Blog just before the Fed made that move:

Instead of what you would expect, [the Fed’s] security holdings since the end of September are down merely $18 billion instead of the expected $50B (the balance sheet as a whole is down by just $14 billion). Bond holdings are still higher than they were at the end of QE and within the range where they had been ever since…. That’s because most of the $12B reduction planned for January will occur on Jan. 31st. (Which may become the day when QT might actually start in honest.)

And so it did, and that’s when the market tumbled. The Fed finally got serious, and the consequences finally got serious.

Then, there is this interesting little graph of the intricate dance between the Fed’s balance-sheet drawdown and the stock market’s recent turbulence:

(Click to enlarge)
Graph by Alex Deluce of GoldTelegraph.com.

During the week that started January 22 and ended January 31, the Fed made a huge reduction in its balance sheet of more than $20 billion. That is the week the market topped out. Right after that drawdown, the market fell off its little cliff. (The dates at the bottom of the graph reflect when the balance sheet action was reported, but the changes could have happened any time during the preceding week that is being reported.) In the week during which the market made its big recovery (from February 7 to February 14), the Fed did a pivot and added a whopping $14 billion back (kind of odd for a Fed that is supposedly in reduction mode.) Having safely ended the market’s fall, the Fed returned to drawdown mode, and the market returned to falling.

It appears to me that the market is closely tracking with every major move on the Fed’s balance sheet.

So, what will happen when the Fed’s unwind increases by another 50 percent in April (going from $20 billion a month to $30 billion) and then when they double in the coming summer what they are now doing?

The zombie Fed is now hacking up its own brainchild by removing $20-billion fingers, one at a time, and the liquidity that is draining out happens to also be the government’s financial red ink, which is its life blood. Ahh, beautiful normalization! Beautiful normalization. With that as the first scene in the movie’s final act, how can anyone still think this story ends well?

 Yield Curve Turns Threatening – Again 

For a while there it looked like the blow-off top of this expansion was somewhere in the future.

Now it’s starting to look like 2017 was as good as it’s going to get – with serious implications for stocks, bonds and real estate.

At least that’s what interest rates now seem to imply. From today’s Wall Street Journal:

Yield Curve Once Again Sends Dour Signal on Economy
A bond market barometer that briefly suggested growth was perking up has reversed course. 
The so-called yield curve, typically calculated by measuring the differential between short- and long-term Treasury yields, has been flattening in the last few weeks.  
Long-term yields have fallen in response to tempered expectations for growth and inflation, even as short-term rates extend their months-long rise. 
The differential between the two-year yield and 10-year yield on Thursday shrank to 0.54 percentage point, the smallest since Jan. 26, coincidentally the day of the S&P 500′s last record high, Tradeweb data show. That was near its January low, which had been the lowest in a decade. 

The yield curve flattened this week as long-term yields fell after a slew of lackluster economic data. Retail sales slipped 0.1% in February, their third straight monthly decline, data showed Wednesday. And data on consumer and business prices showed inflation pressures remain modest. 

Investors watch the yield curve because it can signal that the economy is speeding up when it steepens. It can show the opposite when it flattens. And when short-term Treasurys yield more than their long-term counterparts, it signals that a recession is coming. 
The yield curve also influences portions of the stock market — lifting banks and financial firms when it steepens and pushing up utilities when it flattens. On Wednesday as the curve flattened, the S&P 500 utilities sectors outperformed the benchmark, while the financial sector underperformed. 
Rising yields this year had made the yield curve steeper throughout parts of the winter, but recent economic data has dampened those expectations. At the beginning of this month, the Federal Reserve Bank of Atlanta’s real-time GDP tracker projected the U.S. growing at a 3.5% annual pace in the first three months of the year, but by Wednesday, it had fallen to 1.9%. 
Though some have recently questioned the curve’s forecasting power, many say it still offers a reliable signal. “Periods with an inverted yield curve are reliably followed by economic slowdowns and almost always by a recession,” said Federal Reserve Bank of San Francisco economists, in a research note earlier this month.

Definitively an ominous trend, this, and one that’s consistent with a long-in-the-tooth expansion like today’s. But nothing in this hyper-complicated world is ever simple, so before assuming that a recession is neigh, be sure to note that US home prices jumped 9% in February, import prices rose more than expected, and labor markets continue to tighten. And who knows what the nascent trade war will evolve into.

The take-away? There are even more than the usual number of moving parts to consider this time around. Which means the party can end suddenly via some kind of discreet inflation/geopolitics/stock crash event or very slowly via an accumulation of Fed rate hikes, moderating growth, and rising trade barriers. Either way, “messy” is likely to be 2018’s dominant theme.

Have We Dodged the Secular-Stagnation Bullet?

Kemal Derviş

Women shop in the town of Waynesburg

WASHINGTON, DC – In 2016, Northwestern University’s Robert Gordon published his 700-plus-page magnum opus, The Rise and Fall of American Growth. Two years on, with not just the United States, but the entire world economy experiencing a synchronized acceleration in growth, the second noun in Gordon’s title seems excessively pessimistic, to say the least.
Gordon’s main argument was that the century after the US Civil War – from about 1870 to 1970 – brought an unprecedented economic revolution, as innovations like electricity and piped water rapidly raised productivity and transformed people’s lifestyles. In his view, today’s innovations – especially in digital technology, machine learning, and artificial intelligence – may be breathtaking, but they do not have the same broad productivity-raising potential. Gordon is essentially a supply-side pessimist, though he also points out that income inequality can act as a drag on growth, by lowering effective demand.

Another gloomy take on future growth, advanced by former US Treasury Secretary Lawrence H. Summers after the global economic crisis, has a decidedly more Keynesian or “demand-side” flavor. Summers’ theory of “secular stagnation” (a term first used by the economist Alvin Hansen back in 1938) holds that, in the United States, the desire to save chronically outweighs the desire to spend on growth-enhancing investments.

The balance between saving and investment could be achieved, Summers argues, only with a nominal interest rate that is below the zero lower bound. The fact that ample corporate profits were not being invested seemed to support this hypothesis, which also took root outside the US.

Today’s synchronized growth acceleration does not necessarily invalidate such pessimistic perspectives. After all, Summers – and Gordon even more so – was making an argument about the long term. If the current growth acceleration peters out after six months or a year, they could yet be vindicated. So, in assessing the possibility of weak long-term growth, it is worth looking at where exactly the Gordon and Summers hypotheses are linked, and what would invalidate them.

The lower the expected return on marginal investment in an economy, the lower the interest rate must be for that investment to be made. A low return on investment could be the result of demand-side factors, related to, say, income distribution or financial-sector activities. It could also be rooted in the supply side, with slow technological progress leading to weak productivity growth. In short, the secular stagnation that Summers has predicted, with low interest rates being necessary to offset low returns on investment, could well be caused by the slowdown in productivity-enhancing technological change that Gordon highlights.
It is useful to note, therefore, that what seems to have changed recently is not the supply of savings, but the expected return on investment. The economy is escaping the zero-interest-rate trap not because savings are declining, but because investment is becoming more appealing, owing to improved expectations.

That confidence may be derived partly from the business-friendly tax legislation that was recently enacted in the US. But, more fundamentally, it seems to reflect a shift in the way current and developing technologies are being perceived. Simply put, techno-optimism is gaining ground.

If, controverting Gordon’s thesis, today’s technologies do boost productivity significantly, the return on investment would rise (unless labor receives all of the gains in the form of higher wages, an outcome that nobody expects). That would lift the interest rate that balances supply and demand out of negative territory, solving Summers’ secular-stagnation problem.

It must be stressed, however, that what has changed are expectations, not estimated potential growth. In the US, annualized productivity growth reached 2% in the second and third quarters of 2017, but was negative in the first quarter of that year and zero in the last. According to the World Bank’s recent Global Economic Prospects report, “despite a recent acceleration of global economic activity, potential output growth is flagging.”

So whether or not we are on the cusp of a sustainable acceleration in global economic growth hinges on whether today’s innovative technologies finally have an appreciable impact on labor and total factor productivity. I happen to believe that they will. But the fact is that, so far, they haven’t.

Only if annual productivity growth rises from its current range of 0.5-1% to 1.5-2% in the coming years can one declare that the US has avoided the fate predicted by Summers and Gordon. Today’s economic optimism should not be allowed to obscure that, much less breed complacency about the future. After all, even if technology does meet the optimists’ expectations in terms of its impact on growth, the challenge of ensuring that the added growth is inclusive will remain.

Kemal Derviş, former Minister of Economic Affairs of Turkey and former Administrator for the United Nations Development Program (UNDP), is Senior Fellow at the Brookings Institution.

North Korea: Negotiating on Its Own Terms

By Phillip Orchard

At a meeting in Pyongyang on March 5, Kim Jong Un reportedly told South Korean envoys that he is willing to open talks with the U.S. on abandoning the North’s nuclear weapons if its security could be guaranteed – a departure from Pyongyang’s stance that its nukes would never be bargained away.

During the meeting, according to Seoul, Kim told the envoys that denuclearization of the Korean Peninsula was his father’s dying wish. Potentially underscoring the North’s sincerity, it also expressed an “understanding” of South Korea’s need to resume joint military exercises with the U.S. once the Paralympic Games conclude later this month – and said that it would refrain from conducting nuclear or ballistic missile tests as long as talks were ongoing. This too would be a marked shift in Pyongyang’s position. It previously saw such drills as preparations for an invasion of the North and thus demanded that they be suspended indefinitely in exchange for any freeze in its nuclear or ballistic missile testing (a position supported by both China and Russia).

In April, Kim and South Korean President Moon Jae-in will hold a rare inter-Korean summit at the Demilitarized Zone to push, in part, for U.S.-North Korean talks. Talk is cheap, of course, and North Korea has never cared much for the credibility of its commitments. The two previous inter-Korean summits, in 2000 and 2007, took place under circumstances similar to today, during periods when the North Korean economy was collapsing and when South Korea was ruled by relatively dovish governments. And the agreements reached at both – mostly modest measures aimed to boost cooperation and economic integration – were hailed by all parties involved as landmark steps toward cementing peace on the península.

Yet, neither summit did much to stall North Korea’s long march toward nuclear statehood. The agreement reached in 2000 eventually fell apart and the one reached in 2007 was never really implemented. The main difference this time around is that North Korea is far closer to obtaining a viable long-range nuclear deterrent that it could use to forestall a U.S. attack in perpetuity, drive a wedge between Seoul and Washington and negotiate on regional matters from a position of strength unprecedented in Pyongyang. In 2000, it had yet to conduct a nuclear test. In 2007, it had conducted only one and had demonstrated no major progress on an intercontinental ballistic missile.

So why would it be any more sincere about denuclearizing now? Conventional wisdom says that North Korea’s outreach during the Olympics has been merely a tactical move to buy itself time to complete its nuclear deterrent, gauge the South’s willingness to negotiate on the North’s terms and probe for opportunities to weaken the international sanctions regime. And considering the rapid progress of the North’s nuclear and missile development, its pattern of past behavior and the relatively weak hand the U.S. is playing at the moment, odds are that the conventional wisdom will prove accurate once again. For this reason, South Korea is responding with only guarded optimism, promising to ramp up military cooperation with the U.S. in the meantime. Still, for a country seemingly within reach of a nuclear weapon able to strike distant adversaries, Pyongyang’s apparent about-face is curious enough that we should at least consider what might compel the North to look for a way out of the standoff.

North Korea’s Vulnerabilities

There are three overlapping possibilities that merit close observation, any combination of which is likely to be shaping the North’s strategy.

The first possibility is that the North remains farther from achieving a viable nuclear deterrent than is generally assumed. Despite its progress over the past few years, Pyongyang is still, in most ways, acting out of vulnerability. It is true that the North has demonstrated the ability to fly a ballistic missile far enough to strike the U.S. east coast. But it has yet to demonstrate that it has mastered the technology needed to keep the missile intact and on target as it re-enters the Earth’s atmosphere – by far the most difficult part of ballistic missile development. Without it, the North doesn’t have a deliverable nuclear warhead capable of threatening the U.S. If nothing else, in expressing a willingness to bargain away its nuclear program, North Korea is admitting that it can’t yet strike the U.S. with any degree of certainty.

This means the North remains firmly within the most dangerous window of its nuclear development – it has demonstrated a high probability that it will achieve a full nuclear deterrent, but hasn’t yet done so. The likelihood of a U.S. military operation to address the North’s nuclear program is highest in this phase. So too is sanctions pressure. It’s unclear how long Pyongyang can tolerate the risks of this window. But the steeper the technical hurdles in its missile program become, the more Pyongyang is likely to consider an offramp to the crisis.

This dovetails with the second possibility: that sanctions pressure is getting to Pyongyang.

North Korea is exceedingly adept at getting around sanctions, and its population is well-conditioned to, as Vladimir Putin put it last year, eat grass if needed to support the regime’s nuclear aims. Yet, there have been dozens of recent indicators suggesting that the North is feeling the pain. For example, a South Korean intelligence assessment last month purportedly claimed the North’s hard currency reserves will run out by October. An unconfirmed report citing Chinese sources in January said Kim Jong Un had all but drained the slush fund dedicated to nuclear and missile development. By most accounts, China has been complying with its sanctions commitments by pinching off imports of critical North Korean commodities and capping oil exports across the Yalu River. Condemning sanctions has increasingly become a focal point of the North’s rhetoric, while recent leadership changes in Pyongyang point to an effort to reassure North Koreans about the regime’s command over the economy.

More often than not, it’s impossible to verify these reports. It’s equally difficult to identify a breaking point for the regime in Pyongyang. Sanctions alone will not compel North Korea to capitulate. But the body of evidence suggests that the sanctions pressure is strong enough to, at minimum, become a factor in Pyongyang’s cost-benefit calculations. North Korea’s foremost imperative is regime preservation, and outside powers are not the only threat to its survival. An economic crisis that sows discontent with Pyongyang’s strategy among North Korean elites, undermines the readiness of North Korean forces and perhaps even deprives the North of the resources needed to push through to nuclear statehood cannot be dismissed as a peripheral concern.

The third possibility is that the North is growing increasingly uncomfortable with the threat of a U.S. attack. South Korea has, for the moment, succeeded in persuading the U.S. against an attack, and talk of a punitive U.S. “bloody nose strike” following the North’s next test has since been dismissed by the White House. The U.S. realizes it can’t unilaterally go to war without putting the South at unacceptable risk and thus likely detonating the alliance over the long run.

Big picture U.S. concerns about China outweigh those regarding North Korea, and the U.S. does not want to substantially weaken its position in Northeast Asia. But the U.S. still has an imperative to prevent North Korea from obtaining weapons that could strike the U.S. mainland, meaning Pyongyang cannot be certain that the U.S. can be held at bay indefinitely.

However bloody and strategically costly a military operation might be for the U.S., it would almost certainly mean the end of the regime in Pyongyang.

This, of course, is an argument in favor of pushing forward with its nuclear and missile programs to eliminate the threat for good. But the longer it takes Pyongyang to reach the promised land, the more it will be at risk of circumstances becoming more favorable for a U.S. strike.

Valuable Bargaining Chip

To whatever extent a combination of these factors is molding Pyongyang’s strategy, the North has ample reasons to be actively exploring an alternate means of guaranteeing its security – even if only to give itself options and avoid backing itself into a corner. This could come in a number of forms, ranging from the North putting itself under China’s nuclear umbrella to something as unexpected as embracing the U.S. The most intriguing possibility is that both Seoul and Pyongyang see an opening to move toward some sort of jointly guided reunification process – an exceedingly complicated scenario with no comparable precedent among modern states, but one that could theoretically allow North and South Korea to end their reliance on and much of their vulnerability to foreign powers altogether.

Each of these options would come with myriad downsides, and the lack of evidence for any scenario makes speculation about their mechanics premature. Moreover, none would outweigh the security provided by a viable nuclear deterrent. But the point is, even if the North is indeed nearing a breaking point, it won’t simply hand over its nukes for food aid and sanctions relief.

It’s built an extraordinarily valuable bargaining chip in the form of its nuclear program – one that may still prove too valuable to bargain away. And it’s long history of subjugation to foreign powers is too hardwired for Pyongyang to accept a return to a strategy of merely isolating itself and hoping it gets left alone.

Whether from a position of growing confidence or internal crisis, the North is making its play to negotiate its future on its own terms. We’ll see the strength of its hand when joint U.S.-South Korean exercises resume in April.