Why Trump’s pivot to using tariffs as a political weapon is so dangerous for the economy

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President Donald Trump delivers remarks in the Roosevelt Room at the White House in Washington, May 9, 2019

Jonathan Ernst | Reuters

President Donald Trump prides himself on bold negotiating tactics, but his threat to slap tariffs on Mexico for not cracking down on immigrants turns a powerful trade tool into a dangerous weapon that could backfire.

Trump said Tuesday he will likely carry through with tariffs on the second biggest U.S. trading partner, in a move that analysts say could ultimately hurt him and create an atmosphere of distrust about U.S. policy. The initial reaction on Wall Street was a stock market sell-off and a flight to safety in bonds. And economists both cut their economic forecasts and changed their view in favor of Fed rate cuts this year.

But stocks rebounded Tuesday after it appeared Republicans might oppose the president and try to stop the tariffs on all Mexican products, scheduled to begin on Monday. Even so, the damage is done and Trump has shown a willingness to use an economic tool to get his way on other issues, a risky precedent that could breed deep uncertainty in markets and with allies.

“This is a clear public policy imperative. It is one of the biggest abuses of a president’s authority that I can think of,” said Tom Block, head of Washington policy at Fundstrat. “Most important is we have a trade agreement with Mexico, and we have a new one we were going to put in place, that to the president’s credit, improves on NAFTA” — the North America Free Trade Agreement.

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‘Creating a lot of distrust’

Analysts say Trump’s willingness to slap tariffs on Mexico would lower the bar on putting new tariffs on other trading partners, and makes every trade relationship with the U.S. vulnerable. U.S. and Mexican officials are set to meet Wednesday afternoon at the White House.

“We’re creating a lot of distrust around the world. It’s not easily put back together,” said Peter Boockvar, chief investment strategist at Bleakley Advisory Group. “Even if there’s a China deal of some sort, the adversarial nature of this relationship is only going to deepen.”

Bank of America Merrill Lynch economists now see little chance the new three-way deal, or USMCA, between the U.S., Canada and Mexico, will pass into law. They also say the Mexican tariffs would help pull down second-half growth to 1.2% from their earlier forecast of 1.8% and last year’s 2.5%.

“This is the second downward revision to our forecast this year as a result of the trade war. And with every subsequent action on trade, the pain becomes more severe and threatens to be more persistent. The Fed will not likely sit idle and watch the economy weaken. We are revising our call: we now expect the Fed to cut rates. We look for a 25bp cut in September, another in December,” they said.

The economists said there would also be a hit to Mexico’s economy, and they lowered GDP growth forecasts to 0.7% from 1% for 2019 and to 1.2% from 1.5% for 2020.

In an op-ed piece on CNBC.com Wednesday, seven former U.S. Ambassadors to Mexico warned that the tariffs could not only do damage to the economies, but make the migrant issue even that Trump is trying to solve even worse.

“Higher tariffs will tax U.S. consumers and producers and weaken the integrated production chains that underpin millions of U.S. and Mexican jobs. Damaging Mexico’s economy will cripple its capacity to tackle migrant flows as well as the economic growth that contributed to “net zero” Mexican migration to the U.S. today. Mexico would face a political imperative to retaliate against U.S. exports,” they wrote.

‘Playing a dangerous game’

Dan Clifton, head of policy research at Strategas, said part of what is happening is that Trump’s focus has shifted away from tax cuts and deregulation toward the 2020 election, and he’s making an effort to differentiate himself from the field of Democratic candidates.

“This has resulted in higher tariffs and more regulatory oversight of the tech sector. Higher taxes and more regulation is a toxic mix for risk assets, but will persist until the economic data softens,” Clifton said. “As such, the 2020 election is already infecting financial markets and Trump is playing a dangerous game with anti-growth policies while the yield curve is inverted.”

In the bond market, yields, which move opposite price, have fallen dramatically, though they were slightly higher as stocks surged on Tuesday. When yields invert, the longer-dated notes, like the 10-year, have a lower yield than the shorter-term securities, like the 3-month bill. An inverted yield curve is viewed as a reliable signal of a potential recession.

“I don’t get the logic of using tariffs as the weapon to get Mexico to protect the border. Where does one have anything to do with the other? When U.S. companies are going to get hurt by it, there’s no logic to it,” said Boockvar.

Reserve currency status

Policy strategists do expect Congress to try to stop Trump from moving on Mexico, using an emergency declaration.

“Congress would be voting to stop the emergency declaration at the border which is used to justify the tariffs. We would expect both the House and Senate to pass these measures. However, the President would likely veto and therefore Congress would need veto proof majorities in both the House and the Senate,” said Clifton.

“While this could be achieved in the Senate, there are probably not enough Republicans in the House willing to vote that there is no emergency at the border. Mexico retaliating on the U.S. may help boost votes in the House but it’s still a large bar to clear a veto proof majority in both chambers,” he added in an email.

Senate Majority Leader Mitch McConnell said Tuesday he hoped the tariffs could be avoided. But Trump said early in the day he thought it likely the tariffs, which start at 5%, would go into place and he asked Republicans not to join with Democrats to block him.

“The problem is public policy requires some element of predictability. Surprise helped him get good ratings on reality TV, but nobody can plan anything based on this,” said Block. “It’s just a core principal of public policy. I think there’s a lot of interest in his crowning achievement would be the new NAFTA, the USMCA. How can Mexico or anybody come to an agreement on free trade, when on a whim it can be changed? It’s a really unacceptable way to conduct public policy.”

Block said the U.S. needs to be careful to protect its reputation — and its reserve currency status, though it is currently not threatened.

“The reserve currency is such a national advantage. It’s because of the predictability and rule of law in the United States,” said Block. “There are still a lot of things going for us, but it does create political risk.”

Strategists said Trump’s action has made markets lose trust in him, even if the tariffs do not go into place.

“The damage has been done,” said Jim Caron, portfolio manager at Morgan Stanley Investment Management. Caron said the damage to markets is lasting and it has increased volatility. “The market might look at a friendly tweet and say that’s good but you’re not going to recover 100 percent of what you had.”

Mark Cabana, head of U.S. short-term rate strategy at Bank of America Merrill Lynch, said Trump’s action shows he has no problem having a trade war with multiple countries at the same time, and that raises risks for other potential trade battlefields, like Europe or India.

“It shows that he sees this as a tool that can be used for broader policy purposes, and you can have a trade agreement in place, and he will still feel like it’s appropriate to make a one-off adjustment to tariff policy. And he’s relatively unchecked on the grounds he’s using these tariffs,” said Cabana.

Cabana agreed that there’s a new skepticism in the bond market.

“Even if trade is resolved in six months down the line, we don’t know where the Trump put is. … The Powell put, that is the first one to be struck,” Cabana said.

WATCH: How the tariff risks may impact Fed policy

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