• An anxious tone persisted in risk markets throughout March, keeping equity market implied volatility elevated above the post-crisis average.
  • Concerns related to inflation pressures and tighter monetary policy shifted to threats of a potential trade war.
  • As expected, the FOMC raised the fed funds rate by 25 bps at its March 21 meeting, but its projections for further rate hikes in 2018 were less hawkish than some anticipated.

The anxious tone that emerged in risk markets in early February remained for much of March. Domestic equity markets declined approximately 3% in the prior month, and the VIX Index (S&P 500 implied volatility) traded above its post-crisis average for 70% of the trading days in March. The rise in intermediate and long-end rates also took pause, with the 10-year Treasury yield ending the month 12 basis points (bps) lower. Rising inflation expectations and long-end rates were significant catalysts for the February sell-off in equities, but concerns of a pending trade war captured the attention of market participants in recent weeks.

On March 1, President Trump announced  his administration would impose tariffs on steel and aluminum imports, which would make good on campaign promises he had previously made. Perhaps more importantly, the White House made clear that there would be no exemptions allowed for U.S. allies. Not surprisingly, equity markets responded negatively to such threats, even if the direct economic impact of steel/aluminum tariffs were relatively limited. The greater risk of such measures is the unknown retaliatory measures from other nations, which could spiral into outright trade wars (inflationary and negative for global growth). In fact, European Union officials quickly threatened retaliatory measures against U.S. exports, including Harley-Davidson, Levi Strauss and bourbon. It’s not likely a coincidence that those companies happen to be domiciled in the congressional districts of  House Majority Leader Paul Ryan, Senate Majority Leader Mitch McConnell, and House Minority Leader Nancy Pelosi.

As Exhibit 1 illustrates, many of the top steel exporters to the United States are considered allies (aluminum exporters are similar), and the country notably absent from this list is China, with which the United States has the largest trade deficit (and contentious trading relationship). China has been presumed to be the real target of U.S. trade restrictions, and the United States had already imposed hefty tariffs on Chinse steel, which effectively drove those exports into other markets (and still lowered the price of global steel). By offering no exemptions on the U.S. tariffs, the White House is effectively forcing its allies to enforce similar measures on China, and according to recent reports, the Trump administration has expressed a willingness to soften its stance with allies to help crack down on Chinese trade practices. As such, the White House’s motives are presumed to be well beyond steel/aluminum and much more focused on intellectual property theft and technology transfer. On March 22, the administration announced $50 billion of new tariffs on Chinese products where this issue is most prevalent. In the days before the announcement, Chinese Premier Li Keqiang promised that his government will take efforts to protect intellectual property of foreign investors, and despite the announced tariffs from both the U.S. and China, the overall rhetoric has softened somewhat in recent days.

An all-out trade war would likely be negative for stocks and bonds (growth and inflation implications), and a reduced trade deficit for the United States would also have consequences for domestic asset valuations. In short, a trade deficit corresponds with a current account surplus. In other words, the United States pays dollars for goods, which must either be exchanged for other currencies or invested in U.S. assets. This includes both hard assets (real estate, etc.) and securities. China invests most of its U.S. dollars in U.S. Treasuries (~$1.2 trillion), as well as agency MBS and stocks (~$200 billion each). If China “loses” the trade war and the imbalance is lessened, its portfolio of U.S. assets would shrink as well. In addition to inflation and U.S. budget deficit concerns (via tax reform and increased spending), there would likely be further upward pressure on long-end Treasury yields in this scenario.

Fed Policy

As widely expected, the FOMC raised the fed funds rate by another 25 bps at its March 21 meeting. The official statement maintained a positive outlook for growth and inflation. Market participants were most focused on the updated forecasts of FOMC participants for growth, unemployment, inflation, and the fed funds rate (mostly the latter). Given hawkish comments from new Fed Chair Jerome Powell during his February Congressional testimony, investors were preparing for 2018 projected rate hikes to increase to four. However, the median forecast for 2018 was unchanged from December at three hikes, and one additional 25 bps hike is forecast for 2019. The market was already priced for three hikes in 2018, so there was little impact on market rates following the announcement.

The Fed’s forecasts for GDP and unemployment were improved for both 2018 and 2019, but inflation expectations over the same timeframe were essentially unchanged. This implies a couple of things: one, the increased GDP growth forecast is likely tied to fiscal stimulus, which the Fed doesn’t feel will spill over into price inflation; and two, the fact that the unemployment rate forecast was lowered without increased inflation expectations implies that the Fed has once again lowered its NAIRU assumption (non-accelerated inflation rate of unemployment). NAIRU is effectively a breakeven rate of unemployment relative to inflation, and many economists have questioned the reliability of this measure, which is closely associated with Phillips curve economic theory (i.e., inverse relationship between unemployment rate and wage/price inflation).

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