Investors are familiar with the idea that the market price of an asset represents the equilibrium across a number of possible future economic paths. Yet there are times when it feels much more like a tug of war than an equilibrium. The recent gyrations between the sunny uplands of easy monetary policy versus the stark reminder a few days ago that tariff threats continue to hang over sentiment represents such a time. 
“Hang on a minute,” some may say. “We’ve seen this movie before.” The movie where asset markets take fright, the Federal Reserve rides to the rescue with promises of easy money and cooler heads walk back the trade rhetoric. And yes, some may say that this is simply another sequel to what is now a rather tired franchise. However, if we pause to consider the complexion of the potential new threats around tariffs and the room for manoeuvre the Fed has left, this latest sequel starts to take on a new, more sinister twist.
Only a few weeks back, at the end of July, equity markets made new highs, as hopes of easy policy from central banks around the world boosted stocks. Bond markets had other ideas of course. US 10-year yields hovered around 50 basis points below their January levels, and yet, despite some nervous glances, this was not enough to quell the apparent enthusiasm for stocks. After all, the promise of easy policy with global growth somewhere around trend meant yields had to be a good deal lower. Didn’t it?
We would certainly acknowledge that even as stocks made new highs, the normal burst of enthusiasm that surrounds such an event was oddly muted. While the dislocation to bond yields was indeed being overlooked, confidence remained fragile. Scratch just a little below the surface and the veneer of the equity rally was, and remains, rather thin.
The problem is that bond markets have been pricing not merely a benevolent Fed prepared to offer a few “insurance” cuts; they’re also discounting some risk of a full-scale cutting cycle. Since the global financial crisis, investors have become accustomed to the notion that policy easing is an unalloyed good for asset markets. But, seen in its historical context, when the Fed is cutting, it’s usually because growth is sliding and markets are truly vulnerable. History tells us that insurance cuts are not unprecedented but neither are they that common.
When the Fed trimmed rates on 31 July, the cut was delivered with the comment that it didn’t represent the start of a cutting cycle. What was likely meant as a signal – that while the Fed was prepared to offer a couple of cuts the economy remained in good shape – has in fact boxed the Fed into a corner. Should the Fed be called upon to do more than a couple of insurance cuts, it’s becoming much harder to dress these up as anything other than a full-blown easing cycle.
Little wonder then that the response of bond markets to the new salvo in the trade war was savage indeed: US 10-year yields rallying 30bps in just three sessions to hit the lowest level since 2016, and the front of the curve moving to price in as many as four further cuts by the end of 2020. The idea that the bond market is simply discounting insurance cuts and not a full-blown cutting cycle, in response to a more challenged growth outlook, seems ever more tenuous.
The issue is that any further escalation of threatened tariffs is potentially more disruptive than prior rounds to the US itself. Chinese exporters had only a 7 per cent market share in the goods singled out in the first round of tariffs in 2018; allowing importers to find ready substitutes. But the Chinese export share of goods in the latest round, if implemented, would be 45 per cent and with a fifth of the products relying on China for more than 80 per cent of supply. Thus, there is an inherent non-linearity in the design of tariffs, in that any subsequent escalation on tariffs has the potential for larger disruption to the domestic US value chain and especially so for the consumer. The non-linear reaction in bond markets in the last few weeks is evidence of the market pricing in this risk.
With stocks on quite full valuations despite rather lacklustre earnings growth, there is little cushion to absorb the kind of supply chain shock that an escalation in trade tensions might threaten. The market is also pricing for significant Fed easing, so any incremental support for risk assets from the Fed appear to be reaching a limit. It will be increasingly difficult to dress up any greater urgency in easing as anything other than fears over growth and a shift towards a full-scale cutting cycle.
The tug-of-war between trade tensions and easy policy has been evenly balanced so far this year. However, the balance might be shifting as policy shows signs of fatigue, just as we’ve received another, stark reminder that tariff threats still hang over market sentiment.
John Bilton, head of global multi-asset strategy at JP Morgan Asset Management. The views expressed above are his own and should not be taken as investment advice.