Inventories of US High-Grade Debt Turn Negative for First Time Ever

According to Bank of America Merrill Lynch, “excess demand conditions” in the U.S. investment-grade debt market have pushed dealer inventories of these bonds into negative territory for the first time ever. Primary dealers were net short U.S. investment grade debt for about $240 million.

Investors could do well taking notice and notwithstanding that this bodes well for U.S. investment grade debt going forward, behind this situation lies the specter of an increasingly illiquid market.

While practitioners in the corporate bond market have long bemoaned their inability to transact without having an impact on the price, this phenomenon has also been identified in equity markets. Goldman Sachs has warned that such “weakened liquidity conditions” presaged February’s explosion in implied equity volatility, and that stocks are prone to similar seismic shocks because bid-ask depth has failed to recover.

Tariffs on Chines goods

President Donald Trump has asked U.S. Trade Representative Robert Lighthizer to consider hiking the proposed tariff on $200 billion of Chinese goods to 25 percent from 10 percent, hereby increasing the burden of taxation through tariffs on US consumers while, of course, stepping up pressure on Beijing to change its trade practices. The tariff could be implemented as early as September.

The U.S. Trade Representative released yesterday the following press release:

…

“This week, the President has directed that I consider increasing the proposed level of the additional duty from 10 percent to 25 percent. The 25 percent duty would be applied to the proposed list of products previously announced on July 10.

“The Trump Administration continues to urge China to stop its unfair practices, open its market, and engage in true market competition. We have been very clear about the specific changes China should undertake. Regrettably, instead of changing its harmful behavior, China has illegally retaliated against U.S. workers, farmers, ranchers and businesses.

…

There are a few points from this:

• First, it is easier to evade a 10 percent tariff than a 25 percent tariff in this instance. Increasing the tariff rate is therefore more likely to have a larger effect than the additional 15 percent tariff or tax rate would suggest.
• Second, the tariff or tax is unlikely to hit U.S. consumers before the November mid-term elections. It took several months for the tariff on washing machines to hit consumer prices. So, if this tariff is imposed in September, it will probably not be noticed until the end of the year at the earliest.
• Third, a tariff on this scale may start to negatively affect the U.S. economy. Indeed, the impact on the U.S. could be greater than the impact on other countries. The tariff does not apply to goods made in China, but to goods partially made in China. So, for instance, if only 10 percent of the export is actually made in China, only 10 percent of any loss in demand will hit the Chinese economy, the other 90 percent will hit other countries, which includes the United States, that feed into the supply chain.

Federal Open Market Committee (FOMC) statement

The Federal Reserve did not mention tariffs and trade in its statement yesterday, although the economic implications of the tariff increases must be something that have an impact on their thinking, if the tariff increases are actually imposed.

Instead, the Fed did what was expected and signaled a rate hike in September. There are no surprises from the Fed, which seems to have decided that markets need to have everything laid out for them slowly and clearly using nice short words, so that it is not to allow the chance to misinterpretation.

Bank of England Rate Decision

The Bank of England (BoE) is next up in the list of central banks this week and in all likelihood, the BoE is expected to raise rates from 0.5 percent to 0.75 percent, taking hereby the UK's base interest rate to its highest level since March 2009.

The Bank of England probably should raise rates as wage growth remains firm, the labor market is at full employment and credit growth, while not that alarming, has definitively being picking up. 

Nevertheless, what will matter most is likely to be what the Bank of England could signal as likely to happen next.

Etienne "Hans" Parisis is a bank economist who has advised investors on financial markets and international investments.