Yesterday, after countless demands that the Fed cut interest rates, Trump finally made his first, long anticipated formal demand that the Fed should pursue “some quantitative easing“:
…..The Fed Rate, over a fairly short period of time, should be reduced by at least 100 basis points, with perhaps some quantitative easing as well. If that happened, our Economy would be even better, and the World Economy would be greatly and quickly enhanced-good for everyone!
— Donald J. Trump (@realDonaldTrump) August 19, 2019
The good news for Trump is that he has now fully figured out that he has the Fed in the palm of his hand, as he demonstrated just hours after Powell’s July 31 rate cut when Trump broke the US-China trade ceasefire and re-escalated trade war, in the process sending rate cut odds soaring. The flowchart logic, as shown below, is quite simple: all Trump has to do is engage in action that threatens to destabilize the global economy and Powell – as he certified during the last FOMC meeting – has to respond by cutting further, until he eventually reaches a point where QE may be the only possible outcome (as we explained previously in “How The Fed Is Now Underwriting Trump’s Trade War, In One Chart“).
Obviously extending the logic of the above diagram to its logical conclusion also lays out the path that Trump must follow if he wishes to force the Fed to launch QE. And just in case it is unclear, it involves a “gray rhino”, an economic war, and negative rates.
As BMO’s fixed income team writes today, while economic tensions between the US and China have eased somewhat in recent days after China chose not to respond to being designated a currency manipulator by the Trump Administration, which in turn scaled back tariffs it had threatened to implement on September 1, this de-escalation is in-line with broad expectations of how the conflict between the US and China escalates, with BMO cautioning against losing focus on the ‘gray rhino’ that remains the biggest threat to the global economy.
For those who have not heard the term before, a gray rhino – unlike a black swan – is defined as a high-impact and obvious threat that is ambling toward the economy but is nevertheless underpriced by financial markets. Not surprisingly, a broad and severe global economic war remains the gray rhino that investors must continue to monitor and position against. Meanwhile, BMO defines an ‘economic war’ as a situation in which countries (and their various agents, including central banks, SOEs) engage in acts that are designed to harm a competitor more than to help one’s self. An obvious example of an act of economic war would be a country having its military cyber unit hack another country’s power grid. By contrast, cutting interest rates in order to push inflation upward toward target (even if that act weakens one’s currency and thereby incentivizes the shifting of production away from other countries) does not fit our definition of an act of ‘economic war’.
So almost by definition, sanctions regimes are acts of economic war. So through its sanctions programs, the US is actively engaged in economic wars against prevailing regimes in Iran, Syria and Venezuela. Similarly, the EU committed acts of economic warfare against Russia by imposing sanctions in retaliation for the invasion Crimea, although that war has been allowed to cool to the point of a de-facto truce.
Which brings us to…
The ultimate gray rhino, which is a multi-polar economic war that includes multiple major countries or economic regions actively engaged in economic warfare against each other. Much like shooting wars, economic wars have the potential of drawing in new waves of participants until they globalize and spiral completely out of control. So although the latest US-China developments are encouraging (for now), the latest developments in lesser hot spots like UK-EU and Korea-Japan are not all that encouraging. Based on the movement of asset prices over the past year, we question whether some markets (particularly FX) have adequately factored in the risks.
Here BMO is quick to note that an “ultimate black rhino” scenario is not its base case… however, the odds of one are rapidly rising.
And here is the punchline: if a worst-case scenario unfolds, BMO believes the Fed and other central banks will ease more aggressively, given the escalating risks of recession. And, should a recession scenario become the modal view, the Fed would not hesitate to quickly lower policy rates to the zero lower bound again, partly in the hope that rapid rate reductions could minimize the chance of having to ramp-up QE again or venture into negative rates. Other central banks would follow suit in this “race to the bottom”, that many would be hoping is accompanied with local currency depreciation (even perhaps with a bit of official encouragement).
What does that mean for the US?
An outright economic war would be extremely consequential for the US economy and thus monetary policy and the Treasury market. At a first pass, the Fed would react in terms of the impact on growth, inflation, and financial conditions. Economic war would lead to slower growth causing less inflationary pressure (despite any import tax expansion) and tighter financial conditions. All of this would correspond to the Fed responding in force by cutting aggressively – likely back to the effective lower bound – and – Trump, are you listening – restarting quantitative easing.
In other words, if Trump really wants to pressure the Fed into QE, what he needs to do is simple: unleash global trade war that mutates into global economic warfare, which in turn leaves the Fed with no choice but to launch QE.
Of course, merely launching QE doesn’t assure a happy ending, and indeed BMO warns that since an “economic war” world would be on the verge of a recession, it would have momentous consequences for asset prices, to wit:
Initially, a dramatic flight-to-quality and liquidity into Treasuries would increase downward pressure on US rates across tenors. Eventually, yields would breach the lows of the last cycle when 2s bottomed out at 0.14% 5s reached 0.53%, or said otherwise, both 2s and 5s would go negative.. In addition, 10-year yields would fall substantially further from here, passing the record low of 1.32% in short order before quickly approaching 1.00%.
Said otherwise, if Trump really chooses to pursue this option, he could kill two gray rhinos with one shot: first getting the Fed to launch QE and second he would push (at least) the short-end of the curve below zero, which would mean that the Fed has finally caught up with other central banks, giving Trump no further reason to complain about the Fed. The only downside: the US and the world would be in a historic recession, and unless central banks can stabilize the global economy, a depression would be assured.