The correlation of the Treasury spreads is a key FX determinant

Outlook

We get information overload today in the US--October personal income and expenditure, the PCE, durables, the trade balance, pending home sales, inventories, and weekly jobless claims.

Today the big story is supposed to be PCE inflation but look at headlines and inbox newsletters—about 90% contain the word “tariff.”

The current numbers may end up taking a back seat to the expected numbers. Goldman Sachs reckons the 25% tariff on U.S. imports from Canada, Mexico and China would affect over 43% of all U.S. imports. Yes, it would raise tax revenue and plenty of it, about 1% of GDP—but it would also raise core PCE by 0.9%. That’s if the tariff rate were raised by 8.6%. Raise it by more and inflation goes up by more.

As noted yesterday, core PCE was 2.7% y/y in Sept, the same as Aug, and this time the forecast is for a small rise to 2.8%, although Trading economics goes for 2.8%. Wearily we have to prepare for the usual variations in quotation method, including m/m and 3-month and 6-month averages, plus supercore.

The big question is what are the 2-year and 10-year yields going to do? We can’t avoid knowing about the inflationary effect of the tariffs, so why are yields still dipping? Reuters attributes it to good auctions this week, the holdover from the TreasSec nomination and the oil price drop on the ceasefire. We would add denial by markets to acknowledge that we are on the edge of catastrophe.

A conflicting set of possibilities is the Fed minutes indicating the Dec rate cut is appropriate-—but then the Fed funds rate will have reached the bottom.

The correlation of the Treasury spreads is a key FX determinant. We already see the differential narrowing between the US and Japan, coupled with the suspicion that Mr. Ueda is about to slide in a hike or at least hawkish talk. Japan whispers but hardly any Westerner is attuned. In a logical world, the threat of rising inflation “should” push yields back up and the dollar with them.

That’s the other notable story today--the reversal in the dollar/yen becoming increasingly visible on the charts. This is pure instinct and sentiment, and nothing to do with Japanese data or anything other than the narrowing yield diffs, with a tiny whiff of expectation that Japan is not going to take Trump bullying without a punch or two in return. So far Trump has not singled out Japan by name. But just as the Europeans are fretting and fuming, Japan knows it has been the target in the past and not about to take it sitting down.

Central Bank meetings

ECB December 12.

Fed December 18.

BoE December 19.

Bank of Japan Dec 19.

Forecast

The dollar is mixed, up against some (notably the CAD) and down against some others (including the euro and yen). This reminds us that “the dollar” is not a single thing. Still, it’s messy and it’s hard to identify “sentiment” with so much stuff swirling around. Every determinant is in play—economics, institutions (mostly central banks) and politics.

The US holiday tomorrow becomes a 4-day weekend, although markets are open Friday (and close early). By then everybody will have closed their books for the Nov month and trading in everything should be thin. The worry is that China or somebody else springs a surprise that creates gaps in the Monday open.

The “somebody else” is surely Trump, who can’t abide being out of the spotlight for four whole days.

We continue to expect yields to steady and go back up on the inflation implications of incoming policies, taking the dollar with them. But that may not materialize right away. There’s a lot of noise to come.

Fun Tidbit: Just imagine, a front page story in the New York Times about a currency war with China. For those not in the know, the NYT is hardly the go-to place for economics and finance. But it’s a decent article. “Letting China’s currency, the renminbi, lose value against the dollar would be a tried and true answer to tariffs. A cheaper renminbi would make Chinese exports less expensive for overseas buyers, mitigating the harm to China’s competitiveness from Mr. Trump’s tariffs. Beijing did just that in 2018 and 2019, when Mr. Trump imposed tariffs in his first term.

A devalued currency goes a long way to offset tariffs. But a weak currency drive capital flight and kills consumer confidence, especially after the property bust that erased a big chunk of middle class savings. At the same time, nobody at home or abroad believes the government’s assertion it is maintaining the currency at a “stable equilibrium” level.

Besides, China has work-arounds in the form of assembling stuff offshore so the origin is disguised, plus other tricks, including small shipments that Customs oases over and outright lying. And Chinese exports to the US have not fallen. The best we get from Trading Economics is a rise from $386 billion in 2016, the year Trump won the first time, to $583 billion in 2022. The year 2023 has been updated through Nov 2024, so this is a slowly reported series.

Tidbit: The meaning of Trump’s “America First” is, first and foremost, de-globalization. It has many downsides. First, the ability and willingness of US investors and manufacturers to create substitutes for all the imports is questionable. This is because the cost of land, labor and capital is too high to produce objects like toothpicks and socks at prices competitive with foreign producers. The US is even outsourcing things like AI labelling and the notorious call centers. It’s obvious that the labor shortage in the US means the US cannot compete with low unit-cost foreign producers.

This has always been true. It takes exceptional effort, fat subsidies and strict regulation, and plenty of time for production to shift from foreign shores to the US. Consider the case of Japanese car imports. It took over 20 years for Japanese car companies to move production to the US. Young whippersnappers should go get a copy of the 1986 movie “GungHo” starring Michael Keaton.

And take a look at the mind-boggling plethora of goods we import (https://tradingeconomics.com/united-states/imports-by-category). Some of these things are such high-quality (and based on proprietary designs) that the US cannot compete and still make a profit. Some are literally not available here, like the famous Chinese rare earths, or affordable given environmental regs. Let other countries ruin their environments. 

Secondly, US exports of agricultural products may be “only” about 20% of total exports, but it’s a critical trade-off with important countries like China (also Mexico and Canada). Remember the great soybean debacle of the first Trump administration. He applied tariffs on Chinese goods and China retaliated by cutting dramatically back on soybean purchases. Then Trump brokered what he thought was a deal for China to buy hundreds of millions of dollars of other US exports. In the end, the US had to subsidize soybean farmers for the lost Chinese sales and China never did buy the approximately $300 billion in US goods. Trump is a lousy deal-maker, at least with those not gullible or easily bullied. 

Third, those exporting to the US use their dollar proceeds to buy US assets, mostly US government bonds. Again, the proportion of foreign owners of US sovereign debt may be “only” 22-25%, but that amount means trillions of dollar (https://ticdata.treasury.gov/resource-center/data-chart-center/tic/Documents/shla2023r.pdf). If foreign exporters lose a big chunk of US sales because of tariffs, they will stop buying US Treasuries. Who will replace them? One choice is US investors, who will take money out of real assets and equities if the rate of return gets high enough. Tariffs mean not only inflation for the US consumer, but higher yields.

Higher yields mean a higher cost of debt service, which is already (as of Q4 2024) bigger than the cost of the defense budget. This is intolerable to the those professing conservative values, although for several decades this has been all hat, no cattle. The only president who reduced the deficit was Clinton, not a Republican.

A secondary effect is that mortgage rates, with a high correlation to the 10-year yield, go up—again. The housing market is on its last legs now. The knock-on effect of unaffordable housing is another sharp drop in labor mobility, which used to be a critical factor in the US labor market that other countries did not enjoy. A lack of labor mobility means labor shortages in high-cost housing areas--and rising wages. Instead of rising wages having a regional effect only, wages rise everywhere by some percentage that ends up feeding inflation. The US tendency not to experience wage-push inflation (as has been seen in Europe and post-Brexit UK) is likely coming to an end.

Now couple that with the loss of immigrant workers, not only in produce picking and meat-packing, but all along many supply chains, including construction, home repair like roofing and many, many transportation and warehousing jobs. It’s not sensible to imagine that all the fired US government bureaucrats are going to shift to house-painting, just as unemployed factory workers did not all become computer software programmers in the 1990’s. Some re-structuring of the US labor market is in the cards.

America First is a destructive stance, and that’s without delving into foreign affairs like NATO and other alliances, some of them pertaining to national security (AUKUS) and some to economies (NAFTA).

Bottom line, we do not yet know whether these changes are going to plunge the US into recession. We do imagine an important component of US economic robustness will be taken away. When it comes to the level of the dollar, the total effect cannot be positive. High yields and high risk suggest dollar inflows, but low growth and housing market/labor market turmoil suggest a weaker dollar.

In the glory days of Econ 101, a trade deficit on the order of the US’ deficit would have pointed to devaluation. America First cannot improve it much, if at all. The old formula is coming back--low growth, high inflation, trade deficit-—falling currency. The only thing saving the dollar would be reserve currency status. But have ticked off big Treasury holders who have been looking for alternative for decades, we can’t expect reserve currency status to continue to deliver what the French named “extraordinary privilege.”

Long-term, this is the first step in the decline of the dollar. The only fix in sight is AI and other high-tech goods and services, assuming the US can keep the lead, with China coming up close behind on the rail.  

Note to Readers: Thursday is a national holiday in the US. There are no reports on Thursday or Friday this week. 

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