Kiss The Ring... Trade Negotiations Are Critical

• Escalation then de-escalation was the theme last week, and markets whipsawed. Reciprocal tariffs have been partially rolled back as countries negotiate. But China has been singled out.
• When we find ourselves in unprecedented times, we like to talk through the risks. Downside risks dominate, requiring more accommodative interest rate settings. But even the most optimistic of scenarios demands an RBNZ cash rate below 3%.
• Financial markets were incredibly volatile. Risk assets were dumped and refuge sought – but not in the traditional places. See our COTW for more on the market mayhem.

Here’s our take on current events

The market mayhem continues as Trump’s stance on tariffs changes by the day. Just one week after imposing the largest trade barriers in over a century, Trump announced on Thursday a 90-day pause on reciprocal tariffs—excluding the blanket 10%—for all countries except China. In the escalating tit-for-tat trade war between China and the US, Chinese imports into the US now face a 145% tariff. While American export goods have been hit by a 125% tariff in return. However, pivoting back, it was announced over the weekend that a wide range of electronics – including smartphones, computers, semiconductors, and other devices – would be exempt. And times are changing.

When we find ourselves in unprecedented times, we consider the risks. We have a set of forecasts, all of which can be blown out of the water by recent events. So, what are the risks to the upside, and downside???

Our “upside” scenario is not much better than our central scenario. Damage has been done, and we’re hopeful Trump will deliver “deals”. The upside scenario is called “deals done, move on”. If we get a permanent pivot from Trump, that’s ‘good’ news. But time is of the essence. Trump may pull off some super-fast negotiations and move on to the next thing. Market uncertainty would end. And we’re left calculating the damage to the global economy, which would be significant but not severe.

Maybe we get 10% tariffs (or close to 10%) across the board, excluding China and the EU. It is hard to think of a scenario where China is not hurt, given the retaliations against the US. The same can be said for the EU. Negotiations could see tariffs on some goods, not others. Because Trump has already announced no (or reduced) tariffs on Chinese electronics (Trump must have seen the numerous articles pointing to the new cost of the iPhone…). No matter where the tariffs fall, there will be a ‘supply’ impact on the price, and therefore a reduction in demand. Amazon reacted immediately, by cancelling orders. Those goods need to find a home. And we may see some goods headed to NZ at a discount. Our upside scenario is a terms of trade shock, but not a bad one. Despite the partial rollback of tariffs, China’s economy is still hit harder than the US economy. The EU is also restrained. And the second-round effects shave a chunk off global growth.

Even the most optimistic outlook demands an RBNZ cash rate below 3%. The need to stimulate with a terms of trade shock is obvious. Our forecast 2.5% cash rate is still required, even if we get nothing but good news from here.

Our central scenario takes more time. We factor in much more time to negotiate. We’re talking months not weeks. And it’s all about getting counties to the table, one by one. Trump has proudly touted that 75 countries have fallen at the feet of the US, and are prepared to kiss the ring of the US emperor. China will neither bend a knee nor kiss a ring. And we doubt the EU will either. There’s bad blood here.

Our central view has much lower than all initially stated reciprocal tariffs. 75 countries could get a deal, closer to 10%. The prolonged negotiations leave the global economy in a heightened sense of insecurity. And volatility continues in all markets. Global growth is significantly lower, and the terms of trade shock hits NZ indirectly. Our central scenario demands a more stimulatory monetary policy setting. A move to 2.5% by the RBNZ occurs much faster, and opens us up to a move to 2%, if required.

Special Topic: The downside scenario.
Our downside scenarios are much worse. Reciprocal tariffs come back on close to the initial announcement, with poor negotiating between US, China and others, namely the EU. China and the US find new ways to hurt each other. And both economies are hit hard by the actions of each administration. Trade negotiations take a lot longer to settle, forcing central banks to intervene with financial market dysfunction. Money printing to buy bonds, and possibly other assets, is required to appease frightened investors. And the longer it takes, the worse it gets. There are thousands of ways in which downside scenarios could play out. And the downside risks come with uncomfortably high probabilities. All downside risks end up with materially lower US, Chinese and European growth. Global growth is slashed. The terms of trade shock faced by New Zealand is enough to push the economy back into recession. The RBNZ may be forced to join other central banks in providing a buyer of last resort, especially for Government bonds. It’s possibly a need for QE again. And the cash rate, well, the cash rate of 3.5% needs to be halved, asap. We could easily see the cash rate headed towards 1.5% or lower.

In short, we think our central scenario, with a hint of upside, is the most likely outcome. But the downside risks are heavy and hard to ignore.

From a trading perspective, we would remain in bonds (long). If the central scenario, or upside scenario, play out, we could see a relief run higher in rates. But we still believe a cash rate of 2.5% is required… at a minimum. So, any push higher is likely to meet resistance. And then there are the downside risks. At best, a cash rate of 2% could be reached. At worst, we the bottom could be very deep. A cash rate of 1.5% could quickly become in focus… and there’s still plenty of room to cut from there. We don’t expect this, but it is well within the realms of possibility.

Charts of the Week: Volatility in markets summed up in 6 charts.

A picture is worth a thousand words. So, here’s 6000 words on the volatility in the weeks following Liberation Day. The volatility index, though currently sitting lower, spiked above 50 following Trump’s initial tariff announcement—a level breached only three other times in history. Meanwhile, investors are dumping US assets. And not just equities. In an unorthodox move, US treasuries were massively sold off, with the yield on the US 10yr Treasury spiking. Amidst the bout of risk aversion, investors are questioning the US’s status as a safe haven. Gold however remains a good place to seek refuge.

© Scoop Media