Markets signal to US and China on the trade war: You have 'blundered into a minefield'

Key Points
  • The idea that the U.S.-China trade dispute could turn into something more is starting to become reality.
  • The New York Fed's gauge of recession probability over the next 12 months is now at 27.5%, the highest since the financial crisis.
  • "It's like lighting a match. You think you know how to control it. That's where the uncertainty comes in," said Prudential Financial chief market strategist Quincy Krosby.
President Donald Trump
Joshua Roberts | Reuters

The threat of the U.S.-China trade war escalating into something beyond nasty rhetoric and modestly effective tariffs for the most part has been dismissed by market participants and economists.

But the idea that the dispute could turn into something more is starting to become reality.

Tuesday's relief rally on Wall Street notwithstanding, several under-the-radar indicators are pointing to the danger that a prolonged conflict could put a serious dent into the economy of both nations, and reverberate through a global picture that at best looks tenuous.

Whether it's increased expectations for interest rate cuts, decreasing expectations for inflation or queasy bond and stock market investors who are more aggressively pricing in slower growth, the message is being sent to the U.S. and China that danger lurks.

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"The bottom line here is pretty simple if not altogether positive: markets are signaling that both the US and China have blundered into a minefield," Nicholas Colas, co-founder of DataTrek Research, said in a note Tuesday. "The risk of a US recession is rising, sharply and quickly."

Colas points to the various indicators on inflation, rates and concerns over the Chinese dumping U.S. Treasurys as indicators from the markets that the two sides should heed, much the same way as the Fed took cues that it was making a policy mistake by continuing to raise interest rates.

"When markets signaled to [Fed] Chair [Jerome] Powell that he was on the brink of a policy mistake, he changed course. American and Chinese negotiators could learn from that," Colas wrote.

There is an assortment of concern pointing toward tougher times ahead:

  • The New York Fed's gauge of recession probability over the next 12 months is now at 27.5%, easily the highest since the financial crisis.
  • The Citi Economic Surprise Index, which measures actual data readings vs. expectations, just recently bounced off its lowest reading in nearly two years and remains well in negative territory.
  • Inflation expectations are dimming as well, with the spread between the 5-year Treasury note and the 5-year Treasury Inflation Protected Security — known as the "breakeven" — pointing to 1.75% inflation, below the Fed's desired 2% level.
  • Investors continue to reprice Fed rate actions, with a nearly 50% chance now assigned to a September cut and a 29% probability of two quarter-point reductions before the end of 2019, according to the CME. The change intimates a loss of confidence in growth and expectations that the central bank will have to step in and ease policy. Though Minneapolis Fed President Neel Kashkari told CNBC on Monday that he doesn't see a change in policy ahead, the market feels differently.

The developments come against an otherwise positive economic backdrop.

Unemployment is at a 50-year low, GDP rose 3.2% in the first quarter and small business confidence rose again in April, according to the National Federation of Independent Business survey released Tuesday that showed its index rising 1.7 points to 103.5.

Kashkari also said he sees the U.S. in a more advantageous position than China in the trade battle.

'It's like lighting a match'

Still, the NFIB survey came before the latest round of trade headlines. Market reaction showed that the ecosystem around the economy and the trade headlines remains fragile.

"The economic backdrop is still positive, the market is still up year to date. But the concern now is that this takes on a life of its own," said Quincy Krosby, chief market strategist at Prudential Financial. "It's like lighting a match. You think you know how to control it. That's where the uncertainty comes in."

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During a scrum with reporters Tuesday, President Donald Trump called the situation with China "a little squabble" and said his relationship with President Xi Jinping remains "extraordinary." Stocks rallied strongly after Monday's aggressive sell-off.

But the rhetoric in the trade war has seesawed between confrontational and adversarial, and markets are beginning to focus on the possibility of a negative outcome.

"What happens is once you start to escalate the verbiage and make it personal, and this is true in actual wars and is true in trade wars, then the uncertainty intensifies," Krosby said.

Investors are "moving into a more defensive posture" as the negotiations drag on, with allocations likely to stay that way until there is greater clarity, she added.

"Just like in war, you're looking for escalation or whether or not it can be defused, and then you sit down at the negotiating table," Krosby said. "Investors are waiting for something more concrete and viable, and it may take time."