U.S. stocks and Treasury yields are falling faster than the latest round of disappointing U.S. economic data. The trade war between the U.S. and China is heating up, and both sides are refusing to blink, yielding little optimism for talks to resume. President Donald Trump's gamble to increase tariffs on China is being met with retaliatory threats that are making markets price in a much longer trade war.
The unpredictability of how the trade war will unfold is forcing markets to reprice global growth weakness, as the base case that was firmly in place for a couple of months will not happen. The chief researcher at the China Center for International Economic Exchanges Zhang Yansheng sees both sides testing each other's strategic intentions, which could mean tensions lasting until 2035. While most analysts still think a trade deal will be reached, the uncertainty of the timing is affecting everyone's models in the short term, which could spell a disaster for second half corporate profits.
Yield curve inversions and the possible trigger for a countdown to a recession are wreaking havoc on bond yields. The difference between the yields on the three-month and 10-year Treasuries has once again inverted as the flight to safety sees a deep sell-off with global equities. While the Fed's preferred spread has inverted a few times, the two-year and 10-year curve still has a significant way to go before inverting. The Fed's preferred curve is a better reflection of bank lending, while the two-year and 10-year curve covers shadow banking.
The U.S. economy remains the strongest advanced economy, and even with the latest threat to growth, the Fed's stimulus is expected to help deliver a soft landing. Treasury yields are at multi-year lows, with the 10-year Treasury yield reaching 2.32%, the lowest level since late 2017. Further pressure could hit global markets, and strong demand for Treasuries could drive yields even lower, but that should not signal a longer-term trend.
The market was overdue for a sell-off, whether it was trade driven or earnings based, but the overall fundamentals remain strong for the U.S. economy, and this wave of risk aversion should not last if we get some tariff relief from the world's two largest economies. If we get optimism that a deal is likely to happen, we could see a key bottom for Treasury yields and the U.S. dollar. As long as credit markets remain stable, the labor market continues to shine and U.S. consumer sentiment does not collapse from the recently made 15-year high, risk appetite should return.
Volumes still remain light considering today's selloff, and as we approach the three-day weekend, we could see some exaggerated moves. Price action on the daily U.S. 10-year Treasury note could see resistance from the 126.000 level, as a bearish butterfly pattern could form. The exchange rate between the U.S. dollar and the Japanese yen (USD/JPY), which remains closely correlated to the Treasury yields, could see a bullish butterfly pattern form at the 108.00 level.
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