With the big decline in stocks today, let’s take a look at the historic one-day declines of similar magnitude (or more) … 

This is the S&P 500 futures.  As you can see this roughly 5% or greater decline has some rare company. 

Interestingly, among these severe declines is a down 5.4% day on February 5th of 2018. 

And while it wasn’t directly attributed, at the time, to tariffs, it came just two days before the effective date of a 30% tariff on solar panels and a 20% tariff on washing machines — mostly all having to do with China.

The next day was the low of a 12% decline. 

The decline was from the record highs, and happened over the course of just six days. And it took a little more than six months to regain new record highs.     

Guess what else happened on February 5, 2018?

Jerome Powell was sworn in as the new Fed Chair. 

Trump tax cuts had just been signed into law two months earlier.  And just three days before Powell took the helm, a hot employment report hit, with the hottest wage growth since prior to the Global Financial Crisis.  Government bond yields were already on the move (trading to the highest levels in four years, around 2.7%).  And Trump had just kicked off tariffs. 

From the outset of the Trump administration, the Fed viewed Trump economic policies as inflationary, and started to exit emergency level policies of the prior eight years.  They started a series of mechanical interest rates hikes. 

By the time Powell became Fed Chair, they were several months into quantitative tightening.  And there was clear concern in markets about the potential of a misstep by an inexperienced Fed Chair, in dealing with the unknowns of quantitative tightening.

With that, we have the plunge in stocks today, of similar magnitude to this February 2018 day.  And we have the “tariff” commonality.

Also, like in 2018, we have plenty of Fed influence on the stock market correction.

In the current case, we have a Fed that has hit the pause button, early into the easing cycle, even as they have rates at historically restrictive levels (continuing to put downward pressure on the economy and on inflation).

And, again, they’ve judged, based on their actions and their forecasts, that the balance of risks from the Trump policies would skew toward inflationary.

But both the bond market and the stock market over the past two months seem to be telling us the Fed pause was a mistake. 

As we’ve discussed many times in my daily notes, the turning points in markets over time tend to be determined by some of form of monetary policy adjustment.  You can see it in the chart, just over the past four years.

In the current case, we should expect the Fed easing cycle to re-emerge.

As we head into the initiation of broad-based tariffs tomorrow, let’s take a look at the chart of the U.S. trade balance …

We can see the dramatic trade deficit that developed from the early 90s, driven by China’s economic plan to corner the world’s export market (by manipulating a persistently weak currency).   And it sharply widened leading up to the Global Financial Crisis. 

Then we had Trump 1.0.  And core to the Trump agenda was “structural reform,” meaning balancing global trade.  That came with a multi-year negotiation on trade with China, which resulted in a “phase one” trade deal, but has ultimately delivered an even deeper trade deficit. 

And this recent collapse in the chart is the front loading of trade over the past two months, in efforts to get ahead of tariffs.

Now, if we look back at the trade war of 2018-2019, it was even admitted by Trump that getting any movement on trade (with China) could be considered a success, given the history of the prior twenty-five years. 

This time around?  If we’re wondering if the bark might be worse than the bite, we can look no further than Trump’s Secretary of State selection. 

Marco Rubio wrote a book in 2023 titled Decades of Decadence, which probably got him the job to run the State Department. 

In his book, he has a chapter on China. 

He called the Chinese Communist Party “a totalitarian regime bent on world domination.”  He said the rise of China was the result of “a series of extremely bad decisions, almost all of which were made by the elite political class of the United States.”  And as China rose, “the US government helped them at every step of the way, failing to see the threat that was right before their eyes.”

Also remember, the race for AI supremacy is a two horse race (between the US and China).

And the winner will be the difference between AI that serves humanity and AI that controls humanity (serving the interests of the Chinese Communist Party).  

So, we should expect Trump to leverage tariffs on China to the fullest extent.  

As we discussed last week, the launch of reciprocal tariffs on Wednesday will widen the reach, but the big bang already happened earlier this month, with tariffs implemented on the three biggest exporters to the U.S. (China, Canada and Mexico).

And keep in mind, it has now been nearly two months since Trump’s blanket 10% tariff on China (addition to any existing tariffs).

So, the exasperation over April 2nd has seemed overdone.

And we may have seen that play out in today’s sharp rebound in stocks.  Add to that, later in the day, in an Oval Office press conference, Trump indicated that the reciprocal tariff plan wouldn’t be of equal scale, but rather they intend to be “very nice by comparison,” and “the numbers will be lower than what they’ve been charging us.”

Maybe more important than tariff week, its jobs week.

And we should begin to see DOGE job cuts reflected in this March report on Friday.

As a clue, remember the report last month from the recruitment firm Challenger, Gray showed the biggest layoffs in February since the covid lockdown era, and the depths of the global financial crisis.

It seems obvious that a labor market shock is coming, it’s a matter of when.  The consensus view for Friday is around 140k jobs created and no change to the 4.1% unemployment rate.

It’s an optimistic view.

The question is, will the job market over the next couple of months force the Fed into a more dovish stance on interest rates?

Remember, the Fed has been telling us for the past year that signs of “cracks” in the labor market would be a condition to “react” (i.e. with rate cuts).

With the government job cuts well telegraphed, one would think that Jerome Powell would have acknowledged this labor market inevitability in his last post-FOMC press conference.

Here’s what he said about jobs …

First, he was asked about the Treasury Secretary’s observation that a large amount of the job growth under the Biden administration was government or “government adjacent” jobs.

His response, a dismissive “employment is employment.”

Well, now we have a rightsizing underway of government jobs, which makes this next commentary from Powell’s Q&A of interest:  He said, “what we have is a low firing, low hiring situation,” so “if we were to see a meaningful increase in layoffs, then that would probably translate quickly into unemployment … because it’s not a big hiring market.”

 

Yesterday we talked about tariffs and Trump’s objective to rebalance global trade.  

It’s about China, and the multi-decade economic war it has waged using its currency as a weapon.  That’s led to a wealth transfer, from the West, to China.  And that has led to a structurally fragile global economy.

That said, a weak yuan has been the go-to strategy for manipulating economic advantage, and the formula for its rise to global economic superpower status.  And we should expect China to counter Trump’s tariffs by … weakening the yuan.

If we look back at 2016, in the seven weeks surrounding the election, the Chinese central bank made the largest seven week devaluation of the yuan in a decade — in anticipation of tariffs. 

This time, for Trump 2.0, the yuan is already set around the weakest levels vs. the dollar since 2007.

And if history is our guide (from trade war 1.0), we should expect China to create some leverage in trade negotiations by threatening a big one-off currency devaluation.

What leverage would that create?

A sharp yuan devaluation would (very likely) trigger global financial market instability.  A small one-off devaluation in 2015 sent global stock markets into a sharp fall, on the fear that a bigger Chinese currency devaluation was coming, which could have led to a global currency war, as export competitors devalued to stay competitive.

A currency devaluation threat from China could either 1) put pressure on Trump to negotiate more favorably to avoid a bigger economic fallout, or 2) it could embolden his effort to end China’s economic warfare — perhaps by rallying allies to coordinate sanctions (to put China in the penalty box).   My bet would be on the latter. 

Let’s revisit the coming tariff escalation …

Rebalancing global trade has been a well telegraphed cornerstone of the Trump economic and national security agenda.

April 2nd will widen the reach (with reciprocal tariffs for all trading partners) but the big bang already happened earlier this month, with tariffs implemented on the three biggest exporters to the U.S. (China, Canada and Mexico).  And remember, in just his second week in office, Trump kicked things off by putting a blanket 10% tariff on China (addition to any existing tariffs).

On the latter, as we’ve discussed here in my daily notes, this “trade war” is really all about China. 

And it’s reflected in this chart (and post) …

In short, China is the global producer (the blue bar), we are the global consumer (the light blue bar), and that dynamic has over the past three decades led to the rapid gain in China’s share of global GDP (the light gray bar). 

Why does that matter? 

It matters because this imbalance has persisted (and continues on that path) only because China cheats on its currency (keeping it cheap).

Currencies are the natural balancing mechanism to prevent the bubbles and global imbalances from forming.

If China’s yuan were freely traded, the aggressive growth in the economy over the past three decades would have come with a rise in the value of the yuan (rise in demand of yuan-denominated assets), making its exports more expensive. 

The Chinese would have consumed more with a more valuable currency and richer asset values, and produced less. 

And the global pursuit of cheaper goods would have shifted demand to weaker economies in the world, with weaker currencies, and cheaper assets, which would result in foreign investment, economic development and export-driven growth.  And so the rebalancing cycle would go.

It all goes bad when a major trading partner is deliberately manipulating its currency (keeping it cheap).  But only if its trading partners keep trading with it. 

And Western world politicians have done very little over the years to disrupt the spiral, for a variety of reasons (it’s politically unpalatable … constituents like cheap stuff, governments like cheap credit, and politicians like political and financial favors).

With that, we’ve had a multi-decade wealth transfer. 

China sells us cheap stuff.  We send them the world’s most valuable currency, U.S. dollars.  They offer those dollars back to us in the form of cheap credit (buying our Treasuries), which has fueled more consumption of cheap Chinese products.

This is how China has grown its economy from $300 billion in the early nineties to $18 trillion, and the U.S. debt load has gone from $4 trillion to $36 trillion.

It’s a multi-decade economic war (driven by its currency manipulation).  They have extracted from the world, the largest pile of foreign currency reserves, which they have wielded to exert influence, and expand their economic warfare into hybrid warfare (economic, psychological, biological, information, political and cyber). 

So, dealing with China is priority number one.

Here’s another good visual (U.S. Consumer Durables) that highlights the imbalance timeline.  

In my last note we talked about the recent Fed meeting, and the announcement they made on the quantitative tightening program.

Beginning next month, they will sharply slow the pace that they have been shrinking the balance sheet.

For perspective, let’s step through the history of the Fed’s balance sheet response to the crises of the past 15 years.

If we look back at the housing bust and Global Financial Crisis (GFC) response, the Fed slashed rates to zero.  But they couldn’t stabilize the financial system, until they started outright buying government and mortgage bonds (quantitative easing — QE).

It took not one round, not two rounds, but three rounds of QE to stabilize and promote enough confidence in the economy, to stimulate hiring, investing and spending again.

All along, rates were at or near zero.

Still, the economy stagnated, propped up by Fed life-support for the better part of eight years, and teetering on the edge of a deflationary bust and depression.

Then we had Trump 1.0.

He came in with a pro-growth agenda, and immediately the Fed began raising rates — mechanically taking rates from near zero to 2.5% over the next two years.  And simultaneously, they shrunk the size of the Fed balance sheet (reversing about $700 billion of QE).

So, they pulled the monetary policy life support.

What happened?

The economy grew one percentage point faster than the growth rate of the prior eight years (average annual growth rate), despite the headwinds of tightening monetary policy.

But, by late 2019, the Fed’s attempt to “normalize” policy broke the overnight interbank lending market.

This chart …

 

Remember, the Fed described this as: “strains in money markets that occurred against a backdrop of a declining level of reserves, due to the Fed’s balance sheet normalization and heavy issuance of Treasury securities.”

And they saw it coming — enough to start slowing QT earlier that year, and cutting rates that summer.

But by late September the dam broke (the spike in the overnight lending rate).

The Fed was forced to slash rates, and go back to expanding the balance sheet (QE).

How does this all relate to the current situation?

This time, the Fed has been shrinking the balance sheet for the better part of the past three years — to the tune of about $2.2 trillion.

They slowed the pace of QT last June.

And last week, they dialed it down again from $25 billion to $5 billion a month.  That’s a sharp reduction, to a small amount, which means they have effectively ended QT.

And once again, it was attributed to stress in money markets: “signs of increased tightness in money markets.”

Is this a clue that something in the financial plumbing is breaking, and a Fed response is coming (including QE)?

As we’ve discussed many times in this daily note, we’ve yet to see an example of a successful exit from QE.  Until proven otherwise, it’s Hotel California — “you can check out, but you can never leave.”

On that note, as Bernanke once said, QE tends to make stocks go up.  Stocks went up close to 20% over four months following the Fed’s 2019 response.

We heard from the Fed today.

They held rates steady at 4.25%-4.5%.

Stocks went up.  Yields went down.  The dollar went down.

But if we look at the Fed’s updated projections, they revised growth DOWN and inflation UP.

And while the “median” projection for rate cuts by year-end was unchanged at 50 basis points, the weighted-average target from the 19 Fed officials came in 17 basis points higher than the last time they did this exercise, back in December.

So, in this summary of economic projections, the Fed sees a worse economy, higher inflation and fewer rate cuts than in December.

None of that warrants the market reaction we had today.

But the Fed did something else today.

Beginning next month, they will sharply slow the pace that they have been shrinking the balance sheet — from $25 billion a month, to $5 billion a month.

Why?

As Jerome Powell said in his press conference:  “We have seen some signs of increased tightness in money markets.”

That sounds familiar.

Remember, back in 2019, the Fed spent eighteen months shrinking the balance sheet, draining liquidity from the financial system, and they created a cash crunch (a scramble for dollars in the interbank lending market).

This happened …