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Talk of trade war adds to market fears of monetary tightening

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Talk of trade war adds to market fears of monetary tightening

Talk of a global trade war comes as historically loose monetary policy begins to normalize and financial markets show signs of being unsettled, and it could even prompt central banks to tighten more quickly, analysts say.

With President Donald Trump threatening to raise tariffs on imported steel and aluminum and Europe and China promising retaliation, investors are trying to evaluate the risk to the global economic recovery.

SNL Image
President Donald Trump speaks during a recent meeting on trade with lawmakers at the White House.
Source: Associated Press

Answers are not easy to come by. The last time the U.S. engaged in a major trade war was when it enacted the Smoot-Hawley Tariff in 1930 to help American farmers during the Great Depression, and most economists agree that the resulting chain of beggar-thy-neighbor actions helped extend the depression. Markets now are vastly bigger and much more interconnected, but one model for a "worst-case scenario" of the impact of an all-out trade war found that about 23% of gains from global trade would be eliminated. That's about $1.5 trillion per year, according to research from Ralph Ossa, economics professor at the University of Zurich.

Global exports of manufactured goods were $11 trillion in 2016, according to the World Trade Organization. And while a sudden jump in tariffs on European cars or U.S. bourbon could depress factory output across continents, it would also push prices higher, potentially prompting central banks to act more quickly.

"Central banks would see this as an adverse supply shock, which reduces supply and pushes up prices," said Paul Mortimer-Lee, chief economist for BNP Paribas.

"That might encourage them to raise rates a bit more than they might have otherwise," provided a major trade war does not break out, he added.

"Certainly, POTUS tariff actions ... are clearly creating additional turbulence to the tapering concerns dominating investors' thoughts," Arnim Holzer, portfolio manager at EAB Investment Group, said in a research note.

Central bank fears

The Federal Reserve is already expected to raise rates at least three times this year as central bankers begin to fret about getting ahead of inflation. New York Fed President William Dudley said recently that he would considered even four rate hikes this year a gradual increase. The European Central Bank has already slowed its asset buying program and is looking toward September as a time when it might cease altogether.

For the first time last week, the Bank of Japan, a holdout among major central banks on moving toward normalization, indicated that that could change, as Governor Haruhiko Kuroda said the central bank might consider reducing fiscal stimulus in April 2019.

Sharp falls in world equity markets in February raised fears that the credit cycle may be overextended, with leverage high and spreads tight, said Henry Peabody, diversified fixed-income portfolio manager at Eaton Vance.

"We're not seeing a specific catalyst or event, but risk is beginning to overwhelm return," he said. "While it's not in our forecast for the near future, economic growth may slow, or rising rates may slow growth."

Market response

After dropping in the wake of Trump's announcement, global stock markets rallied this week, an indication that investors believed a trade conflagration was not at hand. Investors' preferred measure of overall market risk, the Chicago Board of Exchange Volatility Index, spiked to more than 25 directly after Trump threw down the gauntlet on tariffs, then settled at about 19 by market close Monday.

By Tuesday, yields on the benchmark 10-year U.S. Treasury had shaved off a few basis points to 2.863%. Yields fall as prices rise. The dollar, which had strengthened Monday, once again declined, with the U.S. Board of Trade Dollar Index down 0.48% at 89.65 by early Tuesday.

Trump said he would have the final statement on tariffs some time this week, though negative reactions from legislators and industry leaders have reportedly delayed the timetable, while the latest round in the renegotiation of the North American Free Trade Agreement ends March 6 in Mexico City.