Wall Street's rough day could mark turning point in trade war

A rapidly escalating U.S.-China trade war drove the worst stock sell-off of the year Monday. Trade watchers warn it may only mark the opening scene of a dark new chapter in the conflict.

Leaders of the world's two largest economies continued ratcheting up their confrontation after U.S. markets closed: The Treasury Department designated the Chinese a currency manipulator. And Beijing confirmed it is canceling purchases of American farm goods in response to President Donald Trump's latest tariffs - 10 percent duties on $300 billion of Chinese imports set to hit in September.

After all three major stock indexes dove Monday - the Dow Jones industrial average was off 961 points at one point, before closing down 767 points, or 2.9 percent - stock futures pointed to another rout before recovering overnight. The People's Bank of China moving is today to set a higher-than-expected level for the yuan, suggesting Chinese leaders may be reluctant to launch headlong into a currency war. At press time, futures for the major indexes were up around 1 percent.

But the market's recent slide has returned the S & P 500 to its level in January 2018, when Trump first launched the trade wars by leveling tariffs on imports of washing machines and solar panels.

And the wider threats remain. Indeed, the danger now is the conflict could spiral well beyond the one-day carnage on Wall Street, with economists and market watchers pointing to the possibility of a global currency war, the permanent delinking of decades-old U. S-China supply chains, and a rising specter of recession.

Trump on Monday morning reached for a familiar villain as stocks started their slide. He again blamed the Federal Reserve for failing to back him up after Beijing allowed their currency to slide past what had been an important psychological threshold of 7 yuan to the dollar. That marked an 11-year low for the currency, a development that will make Chinese exports cheaper, thereby mitigating some of the effect of Trump's tariffs.

Federal Reserve Chairman Jerome Powell last week pointed to rising trade barriers as a menace to growth when the central bank cut its benchmark interest rate by a quarter point, to a range of 2 percent to 2.25 percent. And after Monday's action, bond market investors are now assigning a 100 percent probability to Federal Reserve officials further cutting interest rates at their September meeting, with half projecting cuts between three-quarters of a point and a full point by the end of the year.

But the risks posed by the widening conflagration may overwhelm the Fed's limited ability to mount an effective response (a subject former Obama administration economist Austan Goolsbee explores more here). Yields on government debt plunged around the world Monday as investors sought haven from the possibility of a more severe slowdown in economic growth. In the U.S., rates on 10-year Treasuries hit a low not seen since Trump's election.

And the spread between yields on three-month bonds and those longer-term notes hit their widest point since before the 2008 financial crisis - a phenomenon known as a yield curve inversion, considered a reliable predictor of a looming recession.

In the shorter term, continued escalation between the U.S. and China could pitch the global economy into recession in as little as nine months, Morgan Stanley chief economist Chetan Ahya predicted in a note. "As we view the risk of further escalation as high, the risks to the global outlook are decidedly skewed to the downside," he wrote, per CNBC. "Global central banks, in particular the Fed and [the European Central Bank], will provide additional monetary policy support. But these measures, while helpful in containing downside risks, will not be enough to drive a recovery until trade policy uncertainty dissipates."

But there's an even more fundamental shake-up potentially under way beyond the tit-for-tat retaliation between Washington and Beijing and its shorter-term ravages, Neal Shearing of Capital Economics writes - "namely, we may be witnessing the end of globalisation."

"There is a significant risk that the current trade war between the US and China represents the start of a wider backlash to globalisation that ultimately leads to the disintegration of the liberal rules-based system that has governed the cross-border flow of goods, capital and labour over the past 70 years. It's even possible that this might lead to an eventual Balkanisation of the global economy, with US- and China-led spheres of influence, each with separate payment systems, regulatory standards and technological platforms."

Pressure from existing tariffs and the threat of new ones has already started severing U.S.-China supply chains, as firms that rely on Chinese facilities have shipped production elsewhere.

But developments over the course of the last week appear primed to accelerate the trend, leaving the truce that Trump and Chinese President Xi Jinping negotiated at a G-20 summit in Osaka in late June in tatters. Trade experts now say they see shrinking hope for talks between the countries to head off intensifying hostilities.

The situation started unraveling last week after Treasury Secretary Steven Mnuchin and U.S. Trade Representative Robert Lighthizer returned from unproductive talks in Shanghai with no Chinese commitment to resume buying U.S. agricultural products. Trump responded Thursday by announcing the new round of tariffs - over the objections of his advisers in a heated Oval Office session, per The Wall Street Journal. And the Chinese in turn retaliated by letting the yuan sink, prompting Treasury's designation of the country as a currency manipulator.

Though the designation itself is largely symbolic, Trump could use the currency manipulation label "to justify some combination of (more) tariffs, investment restrictions and export controls," Chris Krueger of Cowen Washington Research Group wrote in a Monday note. Eswar Prasad, a professor of trade policy at Cornell University, tells my colleague Jeff Stein the morphing of a trade war into a currency war could get "very serious ... This could lead the U.S. to essentially shut down all imports from China."

Or as Bloomberg's Shawn Donnan puts it, the U.S.-China faceoff is "starting to look like a forever war - a quagmire with no end in sight, no clear path to a resolution and more potential land mines for an already weakening global economy." Goldman Sachs economists wrote late Monday they now see both sides "taking a harder line, and we no longer expect a trade deal before the 2020 election." Part of the problem, Beacon Policy Advisors' Stephen Myrow writes, is that there is no obvious off-ramp for either side now. Per Myrow, "The president has given no indication that he is willing to pull back on his tariff threat, and even if he wants to, Xi appears unwilling to make yet another deal that is likely to be broken."