In recent weeks, investors witnessed a rare concurrence of market developments. Widespread concern about escalating trade conflicts caused equities to plunge and US Treasury yields to decline. So far, the reaction has been a textbook case of investor behaviour.
Yet, for all the turmoil, the dollar did not prove to be a safe harbour, and has remained weak against major world currencies. The new dynamic holds an important lesson for investors. As President Donald Trump ratchets up the rhetoric on trade, US equities will be hit, Treasuries will provide a safe corner, but the dollar will continue to be unreliable.
The yield on 10-year Treasuries fell over the past month and equities suffered their first quarterly loss since 2015 during the first three months of the year. Amid the market upheaval, the dollar depreciated over the past couple of weeks. It is weaker than it was at the beginning of 2018.
The most recent decline in yields began with Trump’s decision last month to impose steep tariffs on steel and aluminum imports. China retaliated on April 2 with a 15 percent tariff on 120 US products and a 25 percent levy on eight other items.
The US retaliation came on April 3, when the US Trade Representative proposed a 25 percent tax on about 1,300 Chinese exports. Higher value-added sectors such as aerospace and medicine would be among those hit by the new US tariffs. Retaliatory moves continued on April 4, when China announced a 25 percent tariff on a new range of items. Aircraft and soybeans, two of the most important US exports to China, would be affected by the latest action.
The impact on equities and Treasuries was sharp and immediate. US stocks fell on April 2 as investors feared that American exporters and multinational companies in a wide range of sectors would see their revenues slip and their bottom line affected. The technology-heavy Nasdaq Composite Index was one of the biggest victims of the trade tensions. The yield on 10-year Treasuries declined from 2.9 percent on March 20 to 2.73 percent on April 2.
Markets got a respite in subsequent days, taking heart from a statement by Larry Kudlow, Trump’s chief economic adviser, that he expects the two major global economic powers to reach a compromise. This honeymoon for equities ended abruptly on April 5, as Trump ordered his officials to impose tariffs on an additional $100 billion in Chinese products. Only imports valued at $50 billion had previously been targeted. Equities and Treasury yields fell sharply on April 6.
The dollar’s weakening through the trade-related market convulsions was unexpected. Fears about the threat to US corporate profits from a trade war, along with the increased demand for Treasuries, should have pushed investors to find refuge in the greenback, which has generally been the investment destination of choice in stormy times.
Instead, the dollar has depreciated in the past few days and since the beginning of the year. This is not as much of a paradox as it may appear. It resulted from the same supply and demand forces that have shaped equity and fixed-income valuations. Simply put, the currency movement is explained by more funds flowing out of the US than entering.
A US Treasury Department calculation indicated that there was a significant inflow of foreign money to buy Treasury obligations. According to this study, foreign buyers absorbed their largest share of Treasury obligations in February in auctions since May 2016, supplementing the demand from domestic investors. This trend appears to have continued in April.
On the other hand, foreign money exited US equities. American companies may bear the brunt of increased restrictions on their activities in the European Union or China. The bullishness on equities at the end of 2017 and in early 2018 that stemmed from the impact
of the Trump tax cuts has been replaced by trade-related pessimism.
The bearishness on stocks is supported by a study by the Federal Reserve Bank of Dallas, which showed that the proposed tariffs on steel and aluminum are likely to reduce US gross domestic product (GDP) by one-quarter percentage point over the long-run, even if no retaliation by trade partners is assumed. Machinery and equipment will be adversely affected, and capital formation will suffer.
Recent market movements point to what investors should expect in the future: As the proposed trade restrictions increase global risk rather than US sovereign risk, do not expect the dollar to strengthen as prices of Treasuries rises.
Komal Sri-Kumar is the president and founder of Sri-Kumar Global Strategies, and the former chief global strategist of Trust Company of the West