Optimism related to the proposed “Phase 1” trade deal between the United States and China appears to be spreading like wildfire across a wide range of asset classes.

It’s been reported in recent weeks that negotiators from the U.S. and China ultimately decided to try to work in smaller increments toward finalizing a broader trade agreement. This allowed for a change in the tone of the negotiations by pushing some of the thornier issues off the table and allowing negotiators to focus only on items that were less divisive.

In the wake of this perceived progress, global equity indices such as the S&P 500 have broken above resistance and recently notched all-time highs. Gold, often viewed as a safe haven during times of uncertainty, has also lost ground—if only a little—which would appear to confirm that markets are on more stable footing.

Interestingly, the widespread belief that the good times may be about to roll has also moved into the yield curve. This is curious because the Federal Reserve only recently conducted its third straight intervention this year to lower short-term rates by cutting a quarter percent from the federal funds rate at the end of October.

The Fed typically executes rate cuts when things look bleak for the economy, but may have felt pressured to act because the U.S.-China trade war has been such a moving target, and one that has produced more than a few “head fakes” in recent months.

Interest rates in the U.S. across the time horizon, often referred to as the “yield curve,” have consistently reflected the somewhat “on again, off again” nature of trade deal optimism, which could also have factored into the Fed’s decision. 

Earlier in 2019, when prospects for a deal looked bleak, long-term interest rates declined at a faster clip than short-term rates. Economists often lose sleep over behavior such as this because a “flattening” yield curve (one in which rates across the time horizon trend toward each other) is often interpreted as a bad sign for the economy. 

However, long-term rates rebounded recently, meaning the threat of an extended yield curve inversion (a situation in which long-term rates drop below short-term rates) had arguably abated. Long-term yields (U.S. 10-year Treasury) have rallied from below 1.50% in late summer to back above 1.80% in early November. 

Taking all of the above into account, it appears the Fed didn’t want to send any mixed signals regarding their current posture. 

In the press conference after the most recent rate cut, leadership at the U.S. central bank indicated that the action they took was almost like an insurance policy—a preemptive move that simply can’t be interpreted as anything but a serious intent to accommodate. 

Uber-Dovish, in millennial terms. 

The big question now is how long the current trend will hold. Will long-term rates continue to rise (i.e. steepening yield curve) or will that rebound get snuffed out by setbacks related to the Phase 1 deal (i.e. flattening yield curve)?

Chinese negotiators made it clear in recent days that they expect a rollback of $360 billion in tariffs before they put pen to paper on any Phase 1 agreement. That move is straight out of what has essentially become the standard Chinese negotiating playbook—making a significant demand at the 11th hour. 

It was this same tactic that purportedly derailed negotiations earlier in 2019. President Donald Trump’s response at that time was to announce a fresh round of tariffs on goods coming from China. Those same tariffs, in fact, that the Chinese now want rolled back. 

At the end of the day, the fate of the financial markets is just as closely tied to the status of the U.S.-China trade war as it ever was. The only real change is that any potential drop in asset prices (or yields) comes from a higher altitude.

Prepare accordingly.

For more information on the current state of the U.S. yield curve, a comprehensive update was provided recently on an episode of Closing the Gap: Futures Edition presented by the tastytrade financial network. This episode also highlights a hypothetical trade structure that would theoretically benefit from further “steepening” in the yield curve. 

The purpose of this sample position is to illustrate how bond futures can be used to express a market outlook on macro events such as the trade war. Traders may also want to review a previous piece from tastytrade entitled “How Bond Futures React to Rate Cuts” when scheduling allows.

Sage Anderson is a pseudonym. The contributor has an extensive background in trading equity derivatives and managing volatility-based portfolios as a former prop trading firm employee. The contributor is not an employee of luckbox, tastytrade or any affiliated companies. Readers can direct questions about topics covered in this blog post, or any other trading-related subject, to support@luckboxmagazine.com.