2019 Series • No. 19–3
Current Policy Perspectives
Financial Market Implications of the Trade War between the United States and China
The ongoing trade war between the United States and China entered its second year in 2019. Higher tariffs on imported goods have the potential to raise consumer prices, while those firms that cannot easily replace the intermediate inputs they source from China may experience higher production costs and supply chain disruptions. Firms may also choose to delay any capital investments requiring large fixed costs until the policy uncertainty is resolved. Though there are many different channels through which the trade war can affect the economic performance of the United States, the total overall effect is predicted to be moderate. For example, an August 2019 report issued by Goldman Sachs estimates that the total peak effect from the aforementioned channels will amount to 0.2 percent of US gross domestic product.
While it is unlikely that aggregate real economic activity in the United States will suffer many adverse effects stemming from the trade war, this paper establishes that from its inception in 2018, the trade war with China has had a statistically and economically significant impact on US financial markets. The author uses the event study approach pioneered by Rigabon and Sack (2005) to identify 28 event days between January of 2018 and August of 2019 when news events related to the trade war had an immediate impact on high-yield spreads, long-term Treasury rates, and US stock prices.
- News events related to the trade war that increase the Chicago Board Option Exchange’s Volatility Index (VIX) by at least 1 percentage point in annualized implied volatility—which is roughly half a standard deviation for the sample period—would increase high-yield spreads, measured by the Bank of America Merrill Lynch U.S. High Yield Master II Option-Adjusted Spread, by 3.5 basis points. It would also flatten the yield curve by 12 basis points, an effect that mainly stems from changes in the 10-year Treasury rate. Such events would also move the S&P 500 index by about 0.46 percent.
- Of the 28 event days identified by the author, 16 occurred in 2018 and 12 took place in 2019. The events in 2018 coincide with a 34 basis point increase in the high-yield spread, while the events in 2019 coincide with a 13 basis point increase in the high-yield spread.
- The August 2019 inversion of the yield curve for the 10-year Treasury rate and the two-year Treasury rate, which is often taken as an indicator that a recession may be looming, does not seem to have been driven by news related to the U.S. trade war with China. Hence, the media chatter about what this inversion of the yield curve might have been signaling cannot be imputed to the trade war news.
In 2019, FOMC statements and minutes suggest that concerns about the trade war drove some of the rate cut decisions. However, the relationship between the trade war and U.S. financial market movements in 2019 is comparable to 2018, when the Federal Reserve had tightened monetary policy by implementing four 25 basis point rate increases.
This paper finds that the trade war between the United States and China has had a significant impact on high-yield spreads, long-term interest rates, and stock prices. The event dates associated with news about the trade war can explain a large portion of the increase in high-yield spreads and the decline in yields on long-term Treasury debt that has occurred since early 2018. While FOMC statements and minutes suggest that the trade war has been a factor driving the recent rate cut decisions, the relationship between the trade war and financial market movements in 2019 is comparable to 2018, a period when monetary policy had tightened significantly. Moreover, the inversion of the spread between the 10-year and the two-year Treasury rates in August, which generated significant media chatter about a looming recession, does not seem to be influenced by news about the trade war.