Macro-Economic Trading

Trade Deficit Scenarios and Resulting Market Effect

Generally speaking an increase in the trade deficit will weaken the dollar while a fall in the deficit will strengthen the dollar. An increasing deficit means more dollars in the hands of the U.S. trading partners. When they exchange these dollars for euros or pesos, that puts downward pressure on the dollar.

Trade Deficit Increases Because of Strong U.S. GDP Growth

The table above shows that when the trade deficit increases because of strong U.S. GDP growth, the stock market will rally. In this case both Europe and Asia are growing at moderate to strong rates. However, the U.S. economy is growing at a faster clip and will tend to draw in more imports. The stock market views this as a good thing because strong economies around the world spell good news for corporate earnings. The bond market, on the other hand, fearing inflation, may view this as a sign that the U.S. economy is overheating and bond prices will fall.

U.S. Trade Deficit Increase Because of Recession in Europe or Asia

If there is a recession in Europe and Asia, then the deficit may rise because of falling exports. This is bearish news for the stock market. Export dependent sectors like aerospace, agriculture, autos, telecommunications are likely to suffer. The bond market prefers a trade deficit that is a result of weak exports as opposed to increasing imports. This will put downward pressure on interest rates because the U.S. economy will slow and lessen the credit demand of those industries.

U.S. Trade Deficit Increase Because of OPEC Oil Price Shock

If the OPEC cartel suddenly increases oil price, certain sectors in the stock market may view this as a positive event. Energy stocks may rise because of anticipation of stronger earnings while food and pharmaceuticals may benefit from sector rotation. The bond market will assess whether the oil price increase will dissuade the Fed from raising interest rates. The bond Market may rally if it appears that OPEC’s actions are viewed as recessionary and hence put downward pressure on interest rates. Remember that an oil price shock may cause both inflation and recession and there is no easy monetary policy solution to this problem. In any event, we believe it unlikely that the Fed would raise interest rates to combat inflation in the event of an oil price shock.

U.S. Trade Deficit Increase Because the Federal Reserve Raised Interest Rates

The value of the dollar will increase relative to other currencies if the Fed raises interest rates. When this happens, exports become more expensive to sell and imports become cheaper to buy. The trade deficit will most likely increase spelling big trouble both for U.S. export industries and multinational corporations like GE, Honeywell, and IBM that derive a large percent of their sales and profits from abroad. An increase in the trade deficit as a result of rising interest rates and a strengthening dollar will be bad news for both the stock and bond markets.

When the Fed raises rates to strengthen the dollar, European investors will flock to the U.S. in search for greater returns. This will weaken the Euro as investors sell Euros to buy dollars hence possibly fostering inflation within Europe. On the other hand, a weak Euro will help export focused European industries – chemical products, agriculture, mobile phones and so on.

If the Europeans counter the Feds’ action by raising their own interest rates, this will heighten the contractionary effects of the Feds’ rate hikes and lead to global recessionary concerns. The action taken by the Europeans will depend on the state of their economy at the time. If the European economy is weak, it will be difficult for them to counter with a rate hike. If, on the other hand, the European economy is robust and growing nicely and inflation looms as a problem – the Europeans will most likely raise interest rates to match the Feds’ rate hike.

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