The Weekly Fix

Welcome to the Weekly Fix, the newsletter that's wondering how businesses can be expected to boost capital spending when putting on a curve trade in Treasuries seems downright befuddling. –Luke Kawa, Cross-Asset Reporter

The Decision

The widely anticipated first Federal Reserve interest-rate cut in a decade ended up looking a lot more like a hike.

The policy statement reiterated the central bank's pledge to "act as appropriate" to sustain the expansion. "This action" supported progress towards the dual jobs-inflation mandate, while the committee "contemplates the future path" of its benchmark rate amid continued uncertainties about the outlook.

Something for everyone, but perhaps not as dovish as the market was looking for, without any strong nod to additional easing in the pipeline. But at least there was the end of quantitative tightening.

Fed Chairman Jerome Powell muddied the waters in his press conference. The key comment for markets was that the rate cut was a "mid-cycle adjustment to policy."

Traders quickly understood that a mid-cycle adjustment was not an easing cycle, and sold everything except the U.S. dollar. Later, Powell affirmed that the phrase was a contrast with "the beginning of a lengthy cutting cycle." That was like throwing propane on the market bonfire. It left the analysts at JPMorgan Chase & Co. looking good, given that they had warned that everything lookeda little overbought.

The damage was slightly reversed when Powell indicated that he "didn't say it's just one or anything like that" with regard to rate cuts.

All in all, the Treasury move was a twist flattener: two-year yields rose while 10-year yields declined. On the surface, that screams "policy mistake." Under the surface it was worse: both two-year and 10-year real yields rose during the press conference, pointing to market concerns that the monetary policy stance will be too tight.

This was the largest one-day flattening in the 2s10s curve -- the portion of Treasuries that had signaled the least fear about a prolonged easing cycle associated with an economic downturn -- in over a year.

But for all the quibbles that could be made about Powell's communication, it's important to note how little it actually changed the very near-term outlook for the Fed.

The market's base case for easing in 2019 did not change, despite the confusion instilled by the press conference. Heading into the meeting, markets priced in 2.36 cuts of 25 basis points in 2019. Afterwards, 1.14 cuts – plus the one in the bag.

In that sense, perhaps the knee-jerk equity sellers during the press conference overreacted. On the other hand, with stocks up over 20% thanks in large part to higher valuations predicated on lower rates, who could blame an investor for wanting to lock in a great year if a pillar of the bull run appeared to be shaking?

While Powell didn't, in the view of the market, do a fabulous job of articulating why the Fed had cut rates or what good would come of it, everything that happened the next day justified the central bank's decision.

And then some.

The chairman had indicated that risks seemed to be ebbing; with trade concerns going from a "boil to a simmer." Famous last words, as it turned out.

The Aftermath

Trading Treasuries was hard enough after the Fed decision. The curve continued to bull-flatten while America slumbered and ate breakfast amid a rash of data overseas that highlighted the global weakness that spurred the Fed's move.

Then, U.S. ISM manufacturing index missed expectations -- while stopping short of contractionary territory -- underscoring the legitimacy and rationale of the prior day's Fed move. Stocks still managed to erase the Powell-linked decline once the dust settled, while the greenback and yields tumbled. Investors were beginning to accept that nothing had really changed: the Fed stood ready to respond to external threats, the domestic economy wasn't falling off a cliff, and earnings results from corporate America had been better than expected.

Then President Donald Trump kicked up a new cloud. In a tweet around 1:30 p.m. New York time, he announced that tariffs on a further $300 billion in Chinese imports would go into effect at the start of September.

These are the tariffs that hurt. The ones that hit a wide range of consumer goods; the ones that will be more highly visible.

Yields tumbled, as did stocks. There was a slight steepening in 2s10s, but the biggest downward move in the three-month, 10-year spread in over a year. Translation: thanks to an escalating trade war, the easing cycle will be deeper – but not longer – than investors previously thought. Three cuts for full-year 2019 is now the modal scenario.

It was difficult enough for rates traders to contemplate curve trades after the Fed, before trade policy was thrown into the mix. Different curves have spent this week quickly contorting themselves into and out of positions that would earn the admiration of the most experienced yogis.

Steepening is still the default outlook, judging by the forward curve. It's sending Pollyanna signals, pointing to a front end that's poised to fall while the longer end rises over the next year.

But the outlook for short rates -- which had been coalescing -- has been torn asunder.

Five-day front-month Eurodollar price volatility climbed to its highest level since 2010. Front-end vols had been on the verge of un-inverted relative to their longer-dated peers, and quickly spiked again. A fully-fledged trade war was a tail risk; this latest evolution means investors have been forced to attach higher odds to tail-risk scenarios.

There's speculation that Powell will call Trump's bluff -- that is, fail to accommodate an escalating trade war. This is far fetched to seasoned observers, as long as inflation expectations remain more at risk of being un-anchored to the downside than the upside. Powell doesn't control the weather, but he's the only umbrella salesman in town and storm clouds are forming on the horizon.

Still, there's puzzles abound for curve traders. Does a trade war put the zero lower bound within reach? The fed funds futures curve doesn't point to policy rates sinking below 1% yet, so a meaningful bull steepener would require traders placing some odds on the central bank having to slash rates close to the bone. And when, if ever, will breakevens treat the trade war as inflationary? Market-based measures of inflation compensation tumbled, along with oil, as Trump's tweet landed.