Tariff Tango

As the U.S. and China spin around the dance floor, trying to decide who will lead and who will follow, stock markets continue to swing around just as wildly. This morning’s pullback of the tariff escalation caused markets to soar. Driven by short covering, the rally needs more positive news to continue this parabolic move up. It could be prudent to use these opportunities to de-risk portfolios until the final picture arrives, likely toward the end of Q2, before making any longer-term investment plans. We are watching the closes this week as this will give more of a clue on whether this is long-only money coming in or just short covering.

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Avenger’s Endgame  

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Observing today’s market action, the tariff negotiations are a resounding success. We maintain our disappointment that the talks were conducted without our preferred unified Europe-U.S. faceoff against China. Washington chose to go it alone. 

Before the announcement, we wrote the following over the weekend, and this still stands:  

We need to do two things to sift through the static—first is to only focus on comments out of China’s Ministry of Commerce, not Washington. Additionally, we recommend tracking the Hang Seng, the mainland Chinese stock markets, and the Chinese 10-year yield for a better view on how the day-to-day swings in tariff negotiations are going. 

When we take a long-term view, what the markets really need is some sign of globalization getting repaired, even though we fear it will never be the same.  We are concerned that any deal that resembles the 2020 Phase 1 deal and focuses on China developing its consumer market will simply placate markets in the near term. Sadly, the longer-term prospects would be lacking. It is crucial to improve the relationship between the two countries in meaningful ways. Change is essential. We agree with Arthur Kroeber at Gavekal that any successful American reindustrialization must include Chinese direct investment from Chinese high-tech firms. Our view is that it is a nonstarter due to security concerns. Until the distrust dissolves, all we can hope for is the best of a suboptimal set of outcomes. 

Well, we got the baseline, a Phase 1 deal that has China promising, same as in 2020, to stimulate consumer demand. The markets certainly are seeing that short-covering placated relief rally, but for a move that gets us to our alternative path to all-time highs that we laid out over the past few weeks, more substantive change needs to arrive. 

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Powell: I Told You So

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We had written that Fed Chair Powell did not want to cut rates before there was more tariff visibility in case they moved to cut, and then the President abruptly reversed his tough tariff stance, leaving the Fed holding an inflationary bag. With this weekend’s dramatic reversal, he was proven correct. As of Friday, the Fed was thinking stagflationary risks were rising, as seen by the language change in the May meeting statement. The uncertainty remains, but the balance of risks has shifted firmly toward higher inflation without the lower growth worry, at least for now.

Given that the tariff conversations appear far clearer this morning, yet still fluid, the Federal Open Market Committee (FOMC) will be focusing on the four legs of tariff uncertainty that Powell outlined during his press conference: scale, slope, timing, and persistence. Today’s news is positive across all four dimensions and justifies an outlook for fewer rate cuts this year.

Given greater clarity, the fixed income markets are looking at far lower tariffs on top of stimulative tax cuts. That has made investors shift to expecting no rate cuts until September, and just a little more than two by year-end.

In our calendar for this week below, we see that Powell will be speaking at the Fed’s Framework Conference on Thursday. I assume they are scrambling to change his comments. But few can blame him if he walks into the office today with a trace of a smug smile.

We will be watching the NY Fed Survey of Consumer Expectations, which showed an increase in 3-year inflation expectations from 3.0% to 3.2%, while 1-year inflation expectations were unchanged at 3.6%. That gap should not narrow further, given the improved tariff outlook. However, any future report that shows the 3-year horizon rising to converge with the 1-year horizon should make the FOMC anxious because it would show inflation expectations are creeping out into the longer term. We believe that this inflation expectation series (next out June 9) is the one to watch for monetary policy direction. 

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Market Signals to Watch

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Chinese Bond Yields and the Dollar premium are two asset measures that will shed light on the long-term path of risk assets. The 30-year Chinese government bond yield just hit a new low at 2.33%, and yields have been falling steadily since the 4.40% high in 2018. The 10-year yield is at 1.63%, just off the lows of the year. This is a profile of continuing deflation.

The residential property market crisis was the major deflationary force pushing Chinese yields lower. More housing support is needed in their planned big fiscal expansion for this year, since no private demand will come until the tariff risk fully clears. We would need to see 10-year yields base here and start to move up toward the 2025 highs of 1.90% as a sign of an improving economic outlook. We are watching the yield’s reaction to tariff news this week as a gauge. As of last night, the Chinese bond yield rise was somewhat muted, up 5 basis points. The rest of the week will be revealing.

Second, the U.S. Dollar Index has fallen far below fair value. The Dollar moves quite closely with the differential between U.S. two-year interest rates and the two-year yield in other countries. The expected price based on yields values the Dollar Index 5% higher than where it is trading. We believe that is explained by a “policy discount” due to Trump’s tariff moves that caused heavy capital outflows from the U.S. If the China negotiations are to be taken seriously, the gap between where the Dollar should be trading and the actual price should narrow significantly. If there is no improvement, we will become cynical toward positive trade news. 

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What to Look for This Week 

(All times D.S.T.)

1. Tuesday, May 13 at 8:30 a.m. Consumer Price Index for April. March came in at 2.8%, the lowest level since March 2021, depressed by shelter and used cars. We will see if those categories bounce back. The Cleveland Fed Inflation Nowcast expects core CPI to be unchanged at 2.8%. Thursday, May 15 at 8:30 a.m. is April’s print for the Producer Price Index. We will be looking at Core Goods costs, and Trade Services (producer margins), which fell significantly in March.

         At 6:00 a.m. Tuesday, National Federation of Independent Business Survey. Small businesses are among the worst hit           from tariffs, so expect negative headlines.

2. Thursday, May 15 at 8:30 a.m. Philadelphia Fed Manufacturing Inde for May. April’s reading fell a staggering 39 points. The survey’s new orders index dropped sharply from 8.7 in March to -34.2 in April, the lowest since April 2020 during the pandemic. Prices Paid hit 51 last month, the highest since July 2022 when core CPI was approaching 6%.
3. Friday, May 16 at 10:00 a.m., University of Michigan Consumer Sentiment for May. Headline sentiment and Expectations have been falling rapidly to July 2022 lows, and 1-year inflation expectations, normally driven lower by gas prices, spiked to a 40+ year high of 6.5%. The key metric is the five-year long term inflation outlook was unrevised at 4.4% for April 2025, the highest since June 1991, up from 4.1% in March. The NY Fed Survey of Consumer Expectations took a bit of the drama out of this release, because their 5-year ahead horizon fell for the second straight month, and is down to 2.7%.  

FOMC Voters Speaking: Light schedule before major meeting. Powell speaks Thursday May 15 at 8:40 a.m. at the Fed’s two-day Framework Conference, where the FOMC will conduct a 5-year review of monetary policy, reviewing inflation dynamics and the economic implications of their policy strategy. It will be broadcast live at federalreserve.gov for you C-SPAN lovers.

Earnings Note: Tuesday, May 13, Chinese ADRs JD.com and Tencent report, could be something of note in their comments. Toyota and Cisco, Wednesday, May 14. April 29. The highlight of the week will be Walmart premarket Thursday, May 15 with Alibaba, and Applied Materials reporting after the close.