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The Calm Before the Chinese Trade Storm

While a deal can still be saved, the worst case scenario of no trade deal should make the economic environment much more hostile.

With about a month to go before the G20 summit in Osaka, it is unlikely that we will see any more key developments on the trade front between China and the U.S. The U.S. has already declared that it will cut off Huawei from key components and technology, but it has given them a 90-day waiver to “stock up.”

It looks like the Chinese either never intended to make a trade deal and were just stalling to buy time, or they are testing the limits of President Trump, who may have oversold the progress of the trade deal as “90 percent done” and “on the 5-yard line” just days before he tweeted his tariff hikes. It is very likely that the U.S. trade negotiators were mis-led in calculated fashion into this awkward position.

If readers of this column want some top-notch entertainment on how Asians tend to negotiate, I would recommend the 1993 film Rising Sun about the takeover of a fictional U.S. semiconductor company by an equally fictional Japanese conglomerate. Despite the numerous entertaining twists and turns, the film does a good job of delving into the “cloak and dagger” strategies of how some countries negotiate. At any rate, this certainly appears to be true about the calculated last-minute U-turn by the Chinese trade delegation.

If the Chinese have decided to go into a full-blown trade war with the Trump administration, that means they have concluded that they have more to win without a trade deal than with the one that seemed “90 percent done” just a few weeks ago. I suppose we will find out soon enough if the Chinese were merely testing President Trump or had decided long ago not to have a trade deal.

Right now, this trade friction is not yet an economic event, but it has the potential to become one very quickly. This is why the 10-year Treasury yield dropped to 2.29% last week, below the fed funds rate. This is why the eurodollar and fed funds futures markets are calling for an interest rate cut by the Fed!

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The classic slope of the yield curve, as reflected in the 2-10 spread, is still not inverted, even though both the 2-year and 10-year note yields are dropping, as the trade headlines worsen and as German bund yields go further into negative territory. (Europe and Brexit are another big source of global deflation.)

While a deal can still be saved (if the Chinese were merely testing Trump), the worst case scenario of no trade deal (where the Chinese were just buying time) should make the economic environment much more hostile, suggesting further drops in Treasury yields and perhaps a Federal reserve rate cut, especially if the Chinese have decided to devalue the yuan, which would be a deflationary shock to the global economy.

We should not forget that the December 1993 yuan devaluation sowed the seeds of the Asian Crisis of 1997-1998. The 1993 34% yuan devaluation capped a period when the yuan was devalued from 3.73 in 1989 to 8.73 in 1994. The trouble is that the Chinese economy is now 20 times larger, so a devaluation to counter U.S. tariffs and create the necessary inflation to inflate away part of the mountain of debts in the Chinese financial system will have a much bigger effect on the global economy than it did in 1993.

An Anecdote on Chinese IP Practices

I have an acquaintance, a semi-retired tech executive who used to work for a company that makes optical components for telecom equipment in China. My friend relayed and interesting experience he had while working for the company in China.

When the executive arrived in China, his predecessor warned him that there were likely some eavesdropping devices in the offices and that he should take sensitive discussions out of the office (reminiscent of the film, Rising Sun). Our tech executive flew in a sweeping team from Japan (out of concern that any such service delivered within China might be compromised). The Japanese team swiftly presented him with a map of 300 listening devices and warned him not to disrupt the devices as they feared that they will just show up in different locations a month later. Removing eavesdropping devices would be pointless, as this was a normal practice in China.

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