Since the ECB announced a rate cut of 0.1% taking the desposit facility rate to -0.50% and a resumption of bond purchases at a rate of 20 billion EUR per month, the 10 year bund yield has predictably moved from -0.71% to -0.45%, a 0.26% rise, substantial when yields are that low.

The ECB’s move was not as big as the market had hoped for, and yet, it is not clear what the market could have hoped for. Negative rates had not worked for Europe since the ECB cut rates below zero in 2014 and then reduced it further in 2016.

If QE had significant impact on Eurozone growth, it took 2 years to take work, and its effectiveness quickly faded. It seemed from the data that ever increasing amounts of bond purchases would be required to maintain growth, not even accelerate it. Eurozone QE began in early 2015 and Eurozone economic activity sagged in 2016 before picking up in 2017. As QE slowed in 2018, manufacturing has slowed significantly from early 2018 to date (September 2019).

Some of Europe’s problems are specific. While China and the US girded for trade war, Europe has remained trade focused. Its economy is highly reliant on trade with imports and exports representing over 80% of GDP. China’s metric is just over 35% while the America’s is just over 26%.

The EUR has tracked economic growth closely ceteris paribus. The weakness in 2014 was probably due to dollar strength as the US tapered its QE. The impact of European QE supported the economy and the EUR for a while, before growth carried the EUR higher throughout 2017 and Q1 2018. Since then it has been weak.

The Fed meets 18 September and is widely expected to cut rates by 25 basis points. The futures market implies that the probability of a rate cut is 98%. The Fed is in a difficult position. It has already once caved to market and Presidential demands for a rate cut and it may cave once again. The jobs market is tight and earnings are stable. If there are signs of weakness, they lie in PMIs which represent the sentiment amongst purchasing managers, surely dented by the President’s trade war. President Trump wants two things, among others; a trade war with China and rate cuts from his Fed. He is likely to get the second as a consequence of the first.

But other things are evolving. Despite such strong odds for a rate cut, the 10 year treasury yield has risen 44 basis points to 1.9% in the space of two weeks. Inflation has perked up, core CPI rising from 2% in May to 2.4% in August. Disruptions to Saudi oil supply has caused a 10% overnight surge in oil prices. If supply cannot be restored quickly or Yemen makes further successful attacks on Saudi petroleum assets, inflation could be headed higher. But these are mere exogenous shocks to inflation.

Republican Presidencies usually coincide with rising budget deficits and the national debt. The Trump Presidency has seen the deficit rise from 3.1% of GDP to 4.4% of GDP. There seems to be a greater acceptance that fiscal policy will be engaged to address the next downturn. Even in Europe where the Maastricht conditions provide formal guidelines on government debt to be broken, the sentiment towards fiscal rectitude seems to have relaxed. If there is a significant secular change to attitudes it is surely towards engaging fiscal policy. And if the world turns on the fiscal taps, the probability of steeper term structures, and rising inflation, is higher.

Bond markets may not be prepared for this. So far, the narrative is that duration is the safe harbour from credit and equity risk. this will be tested if inflation rises and if a trend towards steepening term structures begins.

If inflation and higher long term rates is the price we have to pay for growth, it will be important what our deficits go to finance. There are two main paths, trickle down economics or wealth transfers through more progressive taxation. If the behaviour of humans over centuries is a guide, we must expect self interest to dominate and trickle down economics to be the chosen route. The fiscal accommodation will work but its effectiveness will be blunted. That means that the price we pay for growth will be very high. If a more progressive tax and spend policy is pursued to effect wealth transfer from rich to poor, the redistribution alone will boost growth, and the deficits will add to it. The price we pay for growth will be lower. But because it will be borne more by the rich and influential, the likelihood of this is lower.

What might change the calculus above is if societal change occurs alongside.

I’ve been of the view, like so many other investors, that the would be dovish and a) launch LTRO early, b) cut rates, and c) do some form of QE (the market thinks outright QE, I thought unconstrained LTRO.)

This view has led me to be long EUR duration from Bunds to Italian and Portuguese treasuries. I have also been long Euro IG credit duration due to the steepness of the credit term structure. This was a over a year ago. It has been a good trade.

The past month has seen in acceleration in these trades. My view, however, has now changed. The European economy has been weak, victim in no small part, of the trade war raging between America and the rest of the world. Economic data suggests the ECB has to be dovish and increase its reflationary efforts. The TLTRO and LTRO calls are based on the details of what the ECB can or cannot do. QE is needed once again but the dearth of German ISINs and the need to buy more peripheral debt is constrained by teh ECB’s need to buy pro rata to its capital key. Repo operations allow the ECB to facilitate private commercial banks to do the buying on its behalf, without these inconvenient limitations.

The risk to the trade has always been political. The end of the Draghi term at the end of this October and the beginning of Lagarde’s leadership of the ECB is a risk.

Christine Lagarde is a consensus builder and communicator. She leans towards dovishness but is likely to be a moderator rather than a leader of the ECB’s policy committee.

On September 4, Lagarde called for European governments to do more in fiscal policy to boost Eurozone growth. While Lagarde is a supporter of monetary accommodation, it was a signal that she at least is listening to the views of the hawks, or that she thinks that further monetary accommodation will have limited impact with rates already through the zero floor. I expect that Draghi may announce another round of QE but a moderate one, (not more than 25 billion EUR of net purchases a month,), disappointing the market’s expectations of further blank check accommodation, or he may simply do nothing but talk, and hand the baton to Lagarde. Lagarde’s September 4 statement is a signal that she will be more circumspect and may demand that member states’ treasuries pick up the slack instead of leaving it to monetary policy.

If so, the impact on rates markets will be negative. Expect curves to steepen and rates to back up.

Inequality has reached acutely high levels. There are certain drawbacks.

1. An important impact of inequality is that the capital and resource allocation decisions are concentrated in the hands of the few. The efficiency of this capitalist, free market, economy, tends to the efficiency of the centrally planned (for example, Soviet) economy.
2. A related theme is that the consumption patterns of the population are distorted by the heavily skewed wealth and income distribution. The needs of the few outweigh the needs of the many.
3. Economic models based on aggregates or averages lose their explanatory and predictive power. Simple adjustments for skew fail to capture the dynamics of income and wealth disparity. Policy designed based on such models obtain unintended outcomes.
4. Inequality results in over saving, which results in a insufficient demand for goods and excess demand for assets.
5. Inequality suppresses interest rates which makes land and capital cheaper and therefore overemployed in production. Labour is forced to compete by restraining wage growth. This is a self-reinforcing feedback loop.
6. A redistribution of wealth from rich to poor would increase the velocity of money and spur economic growth. This is unpopular as it disadvantages the rich and influential and is unlikely to be implemented in a continuous fashion.

I don’t know how yield curves get inverted but when they do, recessions tend to follow after. Why? Banks borrow short term and lend longer term and an inverted curve means that the bank credit market fails to clear. It results in a credit shortage which chokes off growth.

We will still get our recession, but not for reasons of an inverted curve. Not this time.

The corporate bond market is 3 times larger than it was ten years ago. Big companies don’t fund via the banks. The squeeze will be felt by small and mid caps who cannot access the bond market, and households. However, quality consumer loans that get securitized will also escape the credit crunch to some extent as banks lend, warehouse and syndicate.

The curve inversion recession couple will be weaker this time. And yet we will get our recession and this data point will be a spurious one for the history books. All dynamic systems exhibit cyclicality and while policy and central banks have distorted the frequency and phase of the cycle they cannot prevent it altogether. The trade war will raise underlying inflation levels and weaken growth. But mostly, while QE supported growth it also exacerbated income and wealth inequality by rewarding asset owners over labour. Concentration of capital leads to inefficient allocation contributing to eventual decline. We will get our recession but its not the curve.

I have argued since 2013 that the world had been in a trade war since at least 2009, perhaps 2007. This war was fought at various times in the FX theatre and through the re-shoring of manufacturing. Re-shoring represented a reorganization of global supply chains to locate them in the countries of the parent companies. For the US, the main re-shorer, President Obama led a campaign to help facilitate and encourage re-shoring.

The Trump Presidency has been a more belligerent actor in the trade war essentially transforming it from a Cold War to a Hot one. The weapons of choice of the Trump administration are tariffs. Tariffs differ from re-shoring in some respects. In a globalized industrial system, a product begins life in one country and encounters various transformations and value additions in various countries before finding its way to the hands of consumers in a range of countries. Re-shoring aimed to bring supply chains back to the country of origin. Under this policy, an iPhone would be designed and built in America with American components. It would then be sold domestically and abroad, representing exports. In a globally optimized supply chain, an iPhone uses components and intellectual property sourced globally from companies sourcing for components and intellectual property globally. The finished product is shipped from the final fabrication locations, and there can be several, to customers globally. The complex supply chains and end markets result in complex trade relationships, forex flows, and current account dynamics.

Tariffs are a blunt instrument as they tax imports regardless of the multiple nodes of the supply chain, nodes which could reside in the country imposing said tariffs, and its trade allies. Also, it is trivially evident that import tariffs are paid by the residents of the tariff imposing country. Tariffs are also incendiary and invite retaliation. As tariffs proliferate they encourage companies to reorganize their supply chains. This can resemble re-shoring but whereas re-shoring involves bringing manufacturing capacity back to the home country, tariffs encourage companies to produce within the trade blocs of their target end customers. The potential for duplication of resources is high.

At risk of over generalization, in a world of increasing globalization, efficiency is rising and robustness is declining. (By robustness we refer to resilience against supply chain shocks.) In a world of declining globalization, as is likely under a trade war, efficiency is falling and robustness is increasing. Adoption of global standards becomes more difficult. Technologies and industries dependent on global standards and scale may face challenges. Balkanization of industries is a risk which can lead to duplication or incomplete networks. There is a tendency towards higher inflation as sub optimal supply chains are developed around policy and regulation. Cross subsidies of redundant capacity also raises prices.

Declining interdependency further weakens the tendency towards cooperative behaviour raising the risk of international conflict. The trade war between China and America is but one dimension of a wider competition, one for global hegemony. The nature of the competition has until the Trump Presidency been a state of Cold War and passive aggression with both countries engaging throughout their mutual competition. The Trump doctrine seems to suggest a disengagement approach. This approach appears to be part of a wider approach to dealing with the outside world as the US has engaged in various trade disagreements with Europe, Mexico and Canada. The stated intention to reduce participation in the affairs of the Middle East is further evidence of a new insularity. This approach to dealing with China is risky. It risks miscommunication and escalation at the governmental and social level.

The Chinese approach is to build bridges while America builds walls. The insular approach of President Trump represents an opportunity for China to grow its influence. Only the size and inertia of the Chinese status quo has prevented China from furthering its influence and challenging the American hegemony. As the US abandoned the TPP, China could have replaced it, thus confounding and co-opting a project started by then President Obama to counterbalance Chinese influence. The size and depth of SOE penetration in the economy prevented China from complying with TPP standards sufficiently quickly to join the coalition. China has on its side, time. Term limits on the Chinese President have been repealed. China is not a democracy and is ruled by a single party giving it the resolve to pursue long term policies beyond the terms of any Western government. That said, on the US front, the Trump administration’s position on China is largely accepted by the Democrats as much as the Republicans. This makes the China US Cold War durable. Détente is possible but improbable. The challenge for China is maintaining a coherent policy of competitive engagement with a variable US executive. The challenge for the US, is maintaining policy coherence through potentially variable domestic politics, in the face of a consistent and determined Chinese government.