Viewpoint
April 11, 2025 | 15:39
April 11, 2025
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Trade War Collateral Damage |
| Market volatility continues as investors try and digest everything that has transpired on the trade front. After a brief respite from equity selling on Wednesday, as the Trump Administration put a 90-day pause on the most onerous of the reciprocal tariffs against the rest of the world, the trade war quickly refocused and intensified on China. The U.S. doubled down and boosted its minimum tariff rate on China to a whopping 145%. China swiftly responded with a 125% tariff of its own on U.S. exports to China. As a result, we estimate the weighted average U.S. import tariff rate actually increased to 28%, its highest level since 1901. |
| If these tariffs remain in place for any sustained period of time, we will see a rapid disintegration of two-way trade between the U.S. and China. As of February, the latest data we have, U.S. goods imports from China as a share of total U.S. imports sank to 11.0%, its lowest non-pandemic level since 2003. The share of U.S. imports from China peaked way back in September 2015 at just under 24% (Chart 1). The VIX, a measure of near-term market volatility expectations, remains at an elevated 39.2 (as of Friday afternoon). The S&P 500 is trading about 15% below its February 19 peak, approaching two-thirds of the 25% drawdown the market experienced between January 2022 and September 2023, as the Fed aggressively hiked rates and recession fears reached their peak. Even so, the equity market selloff is quickly becoming a side-show for investors and analysts. The real collateral damage is occurring in the U.S. Treasury and corporate bond markets. It doesn’t help that Congress is readying a budget bill that is estimated to increase the federal debt by nearly $6 trillion over the next decade compared to the CBO baseline. Foreign and U.S. investors appear to be losing confidence in the federal government’s management of the economy and its fiscal discipline. The Fed’s trade-weighted advanced economies U.S. dollar index has shed 5.4% of its value so far from its January 13th peak (Chart 2). The 10-Year Treasury yield has jumped to around 4.5%, a 22-bp increase from a month ago. The 30-year Treasury yield has increased 34 bps over the same period. We are now seeing increasing yields from a month ago across a broad spectrum of Treasury maturities. This appears to be driven by a rise in real interest rates as opposed to rising inflation expectations. The real 10-year yield has risen by about 30 basis points over the past month even as inflation expectations at the 10-year horizon have sunk. In short, bond investors are demanding higher real returns in exchange for the risk of holding longer-term U.S. debt. Not a good look for the world’s preeminent safe haven asset. This will make financing the growing federal debt all the more challenging to afford and sustain. Corporate credit risk is rising fast for high-yield as well as higher-quality corporates. High-yield corporate spreads have blown out to around 434 basis points (Chart 3). As recently as February, high-yield corporate spreads were still near historical lows of 256 basis points. Signs of financial market stress abound as investors scramble to recalibrate to a new protectionist global order and the potential breakdown of trade between the two largest economies in the world. If we stay on the current course, I fear we will all be collateral damage in this trade war. |
Dispatches from the Tariffs Front |
| Former U.K. Prime Minister Harold Wilson famously said: “A week is a long time in politics”. It’s also a long time in global trade wars, with this past week proffered as a prime example. The highlights were as follows. Last Friday (April 4), China announced a 34% retaliatory tariff on U.S. goods, matching the 34% reciprocal tariff it would face on April 9. China was one of 57 countries/regions facing reciprocal duties as high as 50% (poor Lesotho), above the 10% base rate. On Saturday (April 5), the global base tariff became effective. It was applied to all countries except for the group that faced higher reciprocal tariffs and the group of 11 nations that were exempt. The latter group included Canada and Mexico which already faced 25% fentanyl/border security tariffs on goods not compliant with the USMCA (and 10% for non-compliant energy, critical minerals, and potash from Canada). For both countries, once the fentanyl/border security tariffs are lifted (when?) they will be replaced by a 12% base tariff (why higher?). Also on the exempt list, are countries the U.S. currently imposes trade sanctions on such as Russia and Belarus along with North Korea and Cuba. Also exempted is Vatican City (think popes over penguins). On Tuesday (April 8), the U.S. retaliated against China’s retaliatory tariff with another 50% levy, for a combined 84% rate effective the next day. Then came wild Wednesday (April 9). As the day began, the reciprocal tariffs became effective, with China’s rate now at 84% (instead of the original 34%). Vowing to “fight to the end”, China retaliated a second time with a matching 50% tariff for a combined 84% on U.S. goods. Meanwhile, the EU voted to begin phasing in previously announced 25% tariffs on more than $23 billion worth of U.S. goods, effective April 15. This was the retaliatory response to last month’s 25% U.S. tariffs on steel and aluminum which was postponed until the reciprocal duties were announced. Canada’s 25% tariff on U.S. automobiles (or the U.S. content for USMCA-compliant vehicles) also kicked in. This was the retaliatory response to last month’s 25% U.S. duties on automobiles and parts that was similarly postponed until the reciprocal levies were announced. However, later in the day, the Trump Administration announced the various reciprocal tariffs would be lowered to the 10% global base rate for 90 days, for all countries except China. In response to Beijing’s latest retaliatory action, the U.S. also retaliated a second time, raising China’s reciprocal rate to 125% from 84%. Including the 20% fentanyl-related levies, China now faces a combined 145% tariff on its exports to the U.S. (This is on top of the duties from Trump 1.0 that continued under Biden.) On Thursday (April 10), the EU announced that it would again postpone its tariffs. And on Friday (April 11), China retaliated a third time, lifting its levy to 125%. Over the past week (Friday-to-Friday), America’s global trade war has morphed into a no-holds-barred battle with China. And the much-hyped reciprocal tariffs are looking more like the ‘global supplementary tariff’ that President Trump ordered be investigated in the America First Trade Policy Memorandum signed on Inauguration Day. Meanwhile, there are Section 232 (national security) trade investigations soon to be completed and likely recommending tariffs. And, according to the Administration, there are almost 70 countries that have reached out to the U.S. for trade negotiations, with Japan and South Korea at the top of the list. We’ll see what happens next week. |
Recession Risks Rising |
| Pundits offered many reasons to explain the President’s partial about-face on reciprocal tariffs. Cratering equities and crumbling confidence in the world’s safest assets (Treasuries) were high on the list. No President wants to be blamed for a market sell-off or, worse, causing a recession. It’s one thing for people to lose a little money (OK, a lot of money), but quite another to lose your job. Together with the trade war’s direct damaging effects on growth—stemming from snarled supply chains, weakened exports, and clipped spending power—are other indirect effects. In our March 21 Viewpoint, we talked about the harm caused by trade uncertainty, with the Economic Policy Uncertainty Index now making a serious run at record highs. Severe unpredictability can delay business investment and big-ticket purchases. We can now add two more fierce headwinds to the list: plunging household wealth and, more broadly, tightening financial conditions. |
| By our estimates, the angry bear prowling the equity woods could erase a year’s worth of American household wealth gains, or roughly $7 trillion (4%). Based on an old rule of thumb that says consumers spend about 3 cents less for every (sustained) dollar loss of equity-market wealth, annual spending could slow by around $200 billion (1%) this year. While rising home prices are providing some offset, they look to moderate this year. Importantly, the negative wealth effect will be stacked upon somewhat weaker labor markets and spending power, as tariffs curb growth and lift inflation. Equity prices are just one of many influences on financial conditions which, in turn, effect the spending decisions of households and businesses. Others include tighter lending conditions and wider credit spreads, which will restrict loan growth. Coupled with uncertainty, both the will and the way of borrowers is being put to the test. Our in-house measure suggests financial conditions have gone from being a moderate tailwind on real GDP growth last year—adding about 1 ppt—to a potential similar-sized headwind this year (Chart 1). While the abrupt shift alone doesn’t flag a recession, it could deepen. And, it’s worth reminding, this hit will be stacked upon the direct effect of the trade war itself, which is now pushing past 1 ppt. |
We all hope—and surely the President aims—to avoid a recession. The best course would be for the trade war to retreat, allowing market casualties to heal. If so, a fundamentally healthy economy would have a fighting chance at resuming its regularly scheduled progress. |