There is some chance that the Bard of Avon would have observed the trade drama with a keen level of interest. In a way, it is he who wrote the script. There would also be some chance that the real-life players, not named Beatrice or Benedick and also not professing love for one another in public, would agree nonetheless to the much-needed dance of celebration in the final act, despite the obvious trail of rumor and deception, as well as quite necessarily more negotiation ahead.
Overdramatic? Am I really? Or do I just look at everything with at least some level of skepticism. The thing I see as the real, significant takeaway from Friday's "Phase One" announcement from the Oval Office is that due to the fact that both the United States and China seriously need a break, that a "break" in the trade war became necessary. As both economies overtly under-perform stated intentions, it became necessary to simply not pour more kerosene on the bonfire. Even then, the Chinese side expresses through the zero-dark hours of Monday morning a need to "talk" more before signing anything. That did not take long.
Phasers on Stun
The dance. This was to be an act of coordinated positivity. Hooray. China has agreed to purchase $40 billion to $50 billion more in agricultural goods over a two-year span. Hurts no one. China has plenty of people. They need to eat. The U.S. runs a surplus and carries a bigger stick economically than other "bread basket" nations. China will promise to try to better protect intellectual properties. Phew, if only we knew that it was that easy. China will welcome large, foreign money center banks to operate within its borders without forced partnerships. We think. As long as this business is conducted in such a way as to draw financial significance toward the communist seat of power (Beijing) and away from parts of the nation that might still have some capitalist-leaning sympathies (Hong Kong). Oh joy.
The U.S. for its part will not increase tariffs on $250 billion of imports as has been scheduled for Tuesday, Oct. 15. The increase on those tariffs from 25% to 30% would not have changed the way the game is played; it's more the fact that a chance to escalate this trade war might pass without such escalation. As we have said, there has been no paperwork put together and nothing whatsoever has passed under the pen of either nation's leadership, so we simply do not have what I would call a deal, my friends. What we have is a trade truce, and a very fragile one at that.
That is indeed still a positive. Work on Phase Two starts immediately? Unless Phase One remains incomplete. Hmmm...
Phase Two is where it gets much rougher. A problem is this: With nothing signed, there still may be nothing accomplished. The paperwork may take weeks. The Chinese side, as we have noted, has already expressed reservation on what seemed agreed to as the weekend began. No currently enforced tariffs are being clawed back. The Dec. 15 deadline for implementation of a 15% tariff on basically all remaining ($160 billion) un-taxed Chinese imports stands unchanged. There seems to have been no U.S. concession made concerning Huawei Technologies. Structural changes in the way China does business with foreign businesses still must be worked out, and a method for proper enforcement as well as settlement of disputes must still be worked out. I'd say a cold war is still on the table.
Meanwhile, equity markets certainly responded well last week to the prospects for some kind of a trade deal, The S&P 500 and the Nasdaq Composite both re-took their respective 50-day simple moving averages (SMAs) on Friday with some rigor, despite suffering a violent pullback over the final 20 minutes of the session. Sell the news, or disappointment in the content? Maybe both.
There is no denying that trading volume printed at considerably increased levels for Friday over Thursday, a second consecutive day of rising prices on rising volume. Advancing volume beat declining volume for the day at roughly five to one. That's an undeniable positive. Industrials and materials led the way. The Industrial Select Sector SPDR ETF (XLI) ran 1.88% and the Materials Select Sector SPDR ETF (XLB) was even better, at 1.94%. Within the materials sector it was chemicals and packaging that stood out. The high-flyer within the industrial sector was the rails. Just look at what the Dow Jones U.S. Railroad Index did on Friday.
This is all a bet on growth. Again, Hooray. Yet who can deny that there was indeed a speculative nature to this action? Who can deny that as high-speed algorithms are where the volume is in 2019, and that while many of these algos are designed to react instantly to headline news, whole others game the momentum?
Well, there was plenty of momentum, as well as plenty of headlines to key in on late Friday. I remain not quite negative, but unconvinced.
I have been asked by a few readers/viewers over either Twitter or e-mail since Friday if these transpiring news events have changed my more defensive stance in any way. My honest answer is this: I think that the weakness in the Chinese economy, not to mention obvious public discontent in certain locales as well as the slowing U.S. macro at the start of an electoral season here, does create a more fertile landscape for progress on the trade scene. I also think that any kind of resolution as far as Brexit is concerned is better than more delays, even if rough at first. Don't forget that earnings season gets moving this week and that the International Monetary Fund (IMF) will hold its semiannual backyard barbecue this weekend. There will be much public opining.
That said, it is my belief the most significant market input that transpired on Friday was the announcement made by the Federal Reserve that it would commence this week (Tuesday, specifically) with an asset purchase program valued at $60 billion per month; it is aimed at expanding a balance sheet that had become quite obviously too small to handle the short-term needs of overnight money markets. This new asset purchase plan that the Fed does not want to call "quantitative easing," or QE, but has already been dubbed POMO for "Permanent Open Market Operations" by those of us who have been calling for this action for some time now, will run through the second quarter of 2020. This will occur while the Fed continues to conduct overnight repo operations in offerings of up to $75 billion apiece for the time being.
Much of the financial media has completely swung and missed on this story, which is quite incredible when one thinks about that. Some who do refer to this program have mentioned it as a restarting of QE, but investors must be cognizant that much of those post-crisis QE programs targeted longer-term debt (the 10-year note?) in a somewhat ill-fated attempt to drive demand for cheap credit.
This new program, as we have called for in this column for many months, will target T-bills only. In other words, while this plan overtly addresses issues of overnight liquidity, it more discreetly appears to be an attempt to repair the yield curve through bluntly pressuring the short end of the curve. Bond markets are closed for a U.S. holiday on Monday. The fact is, though, that debt markets clearly reacted to this news on Friday. Short-term yields did not move higher with the longer end of the curve on trade hopes.
Remember how I have been trying to drive home for readers how much more significant the three-month /10- year spread is in terms of predicting recession than is the more hyped two-year /10- year spread? The three month /10-year spread actually un-inverted on Friday. That's huge !!! The media missed it almost entirely. The significance should this spread remain positive cannot be overstated.
Look at that spike. The answer to your question is still complicated. There will be pressure on the long end, if indeed the Chinese hesitate to move toward Phase Two of negotiation. There will also be pressure on the long end of the curve should a European Central Bank (ECB) that appears to be in a state of fracture still moves forward with its own quantitative easing program in November.
The short answer, though, is this: Should this 'un-inversion" of the three month /10-year actually hold, then most certainly I would need to become less defensive. This is simply a matter of discipline. This is where the prospect for improved net interest margin is born. This is the very first signal of the possibility of a better environment for increased capital expenditure. This is where recession is averted. This is indeed our traffic signal.
Now, can it hold? We really could have done without a federal holiday this day.
Economics (All Times Eastern)
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