Trade and NATO are center stage today. Here we sketch out a few thoughts on trade and NATO, and the equity market reaction. We also look at the record net short speculative position in US 10-year Treasury futures.
The US new tariff threat and Trump’s comments at the NATO summit are among the only things people want to talk about today. Trump’s support in the Gallup tracking poll is steady at just above 40%. But even many American who are not supporters like that the Trump is standing up to what they characterize as free-riders in Europe and which if there is a bipartisan consensus, it is that China is taking advantage of the US.
Turning to NATO, there is much confusion. The 2% GDP target that the US is underscoring was adopted in 2014. The target is a goal not a requirement to be reached by 2024. Of the 29 NATO members, five are thought to have reached the goal while another 16 have plans and are on pace.
The target is about domestic spending. It is not a direct contribution of troops or for specific NATO operations. Importantly, the funds do not have to be used for collective objectives, which is why the US numbers seem so large. US officials project US interest globally, and the relatively large percentage of its budget that is spent on the military is about this global reach not solely for the defense of Europe.
Some, like Ian Bremmer of the Eurasia Group, suggest that Trump’s criticism of NATO undermines Article 5 of the treaty, which calls for collective action and was, for example, invoked at 9/11. While it is possible, it seems premature to reach this conclusion. In fact, arguing that it Article 5 is no longer a real threat could encourage others, like Russia, to step up its probing of what it calls the ‘near abroad” like the Baltics. So far Russia has been careful about pushing NATO members with its asymmetrical warfare tactics.
The US 10-year yield is slightly lower than last month’s close (2.86%). The CFTC Commitment of Traders showed that the net speculative position reached a record low as of July 3 of 500.1k contracts. The nearly 145k contract increase in the net short position was the result of both longs liquidating and new shorts being established.
The bulls have seen a little more than a 30 bp decline in the 10-year yield since peaking near 3.13% on May 18. The yield fell to 2.80% at the end of last week. The bulls cut the gross long position by nearly 79k contracts to 457k. That is the smallest gross long speculative position since late 2016.
The bears have been emboldened. They added 65.9k contracts to their gross short position, which stood at 957k contracts as of July 3. Recall that the gross short position fell from 1.11 mln contracts at the end of May to 891k by the end of June. The increase was the largest in three months.
The S&P 500 gapped higher on Monday and Tuesday. It is poised to gap lower today. Mind the gaps. Yesterday’s is found between 2784.6 and 2786.2. Monday’s gap, which is also found on the weekly bar charts, is found between 2764.4 and 2768.5. Although the S&P 500 set its best closing level since February, it stalled in front of 2800, which has the upper end of where it has been since the February meltdown.
Separately, we note that the MSCI Asia Pacific Index and the Dow Jones Stoxx 600 also gapped lower today. Among individual markets, the Nikkei, Kospi, and Shanghai Composite gapped lower. In Europe, the German, French, Italian and Spanish bourses gapped lower.
One of the under-appreciated sources of tension is the conflicting ways foreign demand is met. The traditional answer is to export. But that is not the case in the US. For historical reasons, the US companies have pursued a direct investment strategy of building locally and selling locally. It is true that the tax arbitrage scheme distorts the picture where profits are booked and the like. However, when thinking about the commercial penetration, the locally produced and local sales are part of the story and not just now but over decades.
China exports to the US were a little more than $500 bln last year, according to the US data. When US local sales are added to US exports to China, the aggregate commercial penetration is around $450 -$500 bln.
The importance of this is not to try to refute that China’s trade practices are unfair, but to highlight the US commercial presence in China is greater than looking at goods trade alone would suggest. It also points to other risks to US companies in addition to tariffs. China may delay licenses for US firms a and postpone approval of acquisitions by US companies. China could boost inspections of US goods. Just because American workers do not directly benefit from foreign direct investment does not mean they will not be hurt if those affiliates are at an economic disadvantage. US companies can move out of China but to do so would be to not only jeopardize the export platform but also risk a large and growing domestic market.
There is also risk that the US tariffs weaken an already softening Chinese economy. It may encourage the PBOC to continue to ease some elements of monetary policy while facilitating the deleveraging. Easier monetary policy in the face of tighter US policy could see the yuan continue to depreciate. China needs to be careful, though, as it does not want to risk a repeat of the vicious cycle of 2015. Currency weakness, equity weakness, capital outflows, weaker yuan, etc. etc.
Lastly, China, like other countries retaliating against US actions, are targeting to some extent Trump’s supporters. Of course, the US cannot target President Xi’s voters. However, that misses a key point. The economic impact, if severe enough, could impact how the US midterm elections go, leaving the US President’s agenda vulnerable in a way the Xi is not. So while the US economy may be better able to withstand the retaliatory tariffs, given the huge fiscal stimulus in the pipeline, the political system is more fluid than China, and that could undermine the President’s agenda.