The tariff crisis is not existential

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

Good morning. On Friday morning, the University of Michigan survey showed consumer sentiment plunging across ages, party affiliations, and income levels. On Friday evening, the Trump administration rolled back tariffs on smartphones. In a country in dire need of distraction, best not to tax the distraction machines. Email us: [email protected] and [email protected]. 

Deep breaths, everyone

Market crises are messy and complex. But last week’s tumult can be summed up, with little loss of fidelity, in three standard charts. Long Treasuries sold off hard, driving yields up:

The dollar fell hard:

And implied equity volatility rose to a five-year high:

It’s the combination of these three that made last week so fearful. When volatility is high, one expects Treasury yields to fall as investors seek the safety of US sovereign debt. That didn’t happen. When we see yields rise, we expect the dollar to rise, as international rate differentials widen. That didn’t happen, either. 

The picture is simple: the Trump administration’s economic policymaking has been unpredictable and incompetent at a moment where high deficits and lingering inflation worries mean there is no room for amateurism. Yields are likely to remain volatile. Global investors are responding to this fact by demanding higher yields for owning Treasuries. The sell-off of Treasuries has pulled the dollar down. All of this has been amplified by the reversal of highly leveraged hedge fund trades that are no longer tenable in a high volatility environment.

This feels momentous, because the reliability of the dollar and Treasuries are the foundation of just about every global market. If things don’t get better soon, who knows what might happen. 

Time to take a step back. Five things to keep in mind:

• Don’t read too much into markets at the point of inflection. Portfolio managers of all sorts are rearranging their holdings in a great rush. This causes dislocations, some of which will be temporary. A day, a week, and a month from now things will look different. It is too early to declare that the supremacy of the dollar is ending, and that Treasuries will never again hedge risk, or that US equity outperformance is a thing of the past.

• The weakening of the dollar and the rise in yields are not extreme. As the charts above show, the dollar has returned to its level before the presidential election, and yields to their level of February. The moves have been frighteningly fast, but they have not gone frighteningly far. 

• When the market ups the ante, Trump folds. Trump now backed down to market pressure twice in a few days, first on the “reciprocal” tariffs on everyone but China and then on Chinese electronics. This may not reduce the policy risk premium on US assets. Unpredictability remains when policies are rolled back ad hoc. But it will reduce the short-term economic damage. 

• At a high level, the move in yields is logical. Tariffs increase inflation risk and the US fiscal situation is up in the air. Also, James Egelhof, chief US economist at BNP Paribas, pointed out to me that if Trump achieves his objective of lower trade deficits, that could push yields up, too. Trade deficits and capital inflows have to match. If the former comes down, the latter will too, and that likely means less Treasury demand and higher yields. 

• The economy is strong. The US added 228,000 jobs last month. Inflation is falling. Earnings have been healthy. Yes, we are sailing into uncharted waters. But the ship is sound. 

Good luck this week. 

Lessons from the 1973 oil crisis

The Fed is in the hot seat. It is expecting something akin to stagflation from Trump’s tariffs. If those expectations are realised, the bank will have to choose between its employment and price stability mandates. Meanwhile, the Treasury market is straining, and there is speculation the Fed might have to intervene, and the bank has signalled that it is ready to do so. In the background, the US’s fiscal situation is up in the air: Republicans are aligned on tax cuts but not spending cuts. 

All this rhymes a bit with the last time the Fed dealt with stagflation: the 1973 oil crisis.

The standard account runs as follows. Arthur Burns, Fed chair from 1970 to 1978, did not do enough to restrain inflation after a series of fiscal shocks in the early 1970s — excesses of the Vietnam war, Nixon’s wage controls, and a change to the global currency regime. He was not firm enough when the oil crisis hit in 1973, either, leading to severe stagflation. Paul Volcker, his successor, pushed rates through the ceiling, caused a recession, and crushed inflation so badly it didn’t return for half a century. He has been lionised ever since. 

Burns gets an unfair rap — Volker cut the fed funds rate when the economy cratered, too, and Burns had to contend with global macroeconomic shifts that were hard to navigate. But the lesson remains. Letting inflation run rampant, and allowing long-term inflation expectations to rise, is more poisonous to growth than a one-time crash. Central bankers “look through” an inflation shock at their peril, and ours.  

Powell — and most other central banks — have sought to emulate Volcker, and focus on prices. After a damaging delay, they did not look through the 2022 inflation surge. In recent statements, Powell has batted away questions about a recession and zeroed in on inflation, particularly whether or not long-term inflation expectations are anchored. By most measures they still are.

Our guess is that Powell will resist cutting too early and risking a Burns-style event. But, in some ways, his situation is even trickier than Burns’s. An oil shock is much more obviously stagflationary than tariffs. At the time, the US and world economy was more reliant on oil, and expensive energy led directly to both slower growth and hotter inflation. The effect of tariffs is harder to predict, in part because they have been low for so long. Luckily, Powell is starting out from a much more benign inflationary environment. Thursday’s headline CPI was 2.4 per cent, against 7.4 per cent at the start of the Opec embargo.

Investors and the Fed will be watching inflation expectations closely. By the Fed’s preferred measure, which uses both Treasury bonds’ movements and survey data, they are still restrained. But there is an asterisk next to those numbers. Soft data like the Michigan survey suggests longer-term expectations could be rising. If unemployment should rise before inflation does, the Fed could cut at precisely the wrong time, and the similarities with 1973 could deepen. 

(Reiter)

One Good Read

The spy’s son.