Bond Traders Hostage to Tariffs in Summer of Unwanted Volatility

(Bloomberg) -- Bond traders got schooled this week in just how pivotal U.S.-China trade relations are for the direction of yields.

In a week that featured the Federal Reserve's first rate cut since 2008 on Wednesday, Treasuries saw their biggest action a day later, when President Donald Trump abruptly escalated trade tension. In the aftermath of his Thursday tweets unveiling plans to slap a 10% tariff on $300 billion in additional Chinese imports, 10-year yields swooned to the lowest level since 2016.

Yields were already falling as the Fed's quarter-point rate cut, combined with Chairman Jerome Powell's signal that an extended easing cycle was unlikely, hammered inflation expectations. Powell cited trade tension as one justification for the policy move, and he added that the Fed was struggling with how to assess -- and respond to -- the impact of Trump's trade policies.

The tariffs “are a problem because they lead to slower global and domestic growth, which is why it's being reflected in lower interest rates,” said Steven Ricchiuto, chief U.S. economist at Mizuho Securities USA LLC. The current period “is reminiscent of the problem central banks had in the late 1970s, when we had stagflation -- something no one understood or knew how to address.”

Ten-year Treasuries yield 1.85%, down 23 basis points this week. The yield touched 1.83% Friday, its lowest since Nov. 9, 2016, the day after the U.S. presidential election. The 10-year breakeven rate -- which reflects expectations for annual gains in consumer prices -- sank as low as 1.64% this week, from 1.78% a week ago.

As Trump's Twitter salvo roiled markets Thursday, volatility jumped, spoiling traders' efforts to turn their focus to August vacations.

One measure of bond-market volatility, Bank of America Corp.'s MOVE Index, surged Thursday by the most since May. It rose further Friday.

In the week ahead, there's little to divert traders' attention from the ebbs and flows of trade relations, or to provide much insight into policy makers' likely path on borrowing costs. There are only a handful of Fed speakers on the docket, and investors will have only a few data points to monitor, including reports on the services economy and producer prices.

Futures show traders now expect about 50 basis points of additional Fed easing this year.

“The ‘uncertainties' that the Federal Reserve worries about -- trade and a weaker global growth story -- are being ratcheted up, and the Fed looks set to follow this week's rate cut with another 25-basis-point move in September,” James Knightley, chief international economist at ING Groep, said in a note. “What happens thereafter depends largely on how trade talks progress.”

What to Watch

Here's the economic calendar
- Aug. 5: Markit U.S. services PMI; ISM non-manufacturing
- Aug. 6: JOLTS job openings
- Aug. 7: MBA mortgage applications; consumer credit
- Aug. 8: Jobless claims; Bloomberg consumer comfort; wholesale trade/inventories
- Aug. 9: Producer price index
It's a slim calendar for Fed speakers
- Aug. 5: Governor Lael Brainard discusses payment systems
- Aug. 6: St. Louis Fed President James Bullard on U.S. economy
- Aug. 7: Chicago Fed President Charles Evans media breakfast/conversation on the economy
- Auction calendar is highlighted by the refunding:
  - Aug. 5: $39 billion of 3-month bills; $39 billion of 6-month bills
  - Aug. 6: $38 billion 3-year notes
  - Aug. 7: $27 billion 10-year notes
  - Aug. 8: 4-, 8-week bills; $19 billion 30-year bonds