Transcript:

There’s this notion that Trump has that if we run a trade deficit we lose, and if we run a trade surplus we win. That’s just not the way it works.

On the flip side of the United States running a large trade deficit, we get the benefits of being able to essentially buy as many goods and services as we want relative to a much smaller number of goods and services that we sell. The good news behind that is that we pay dollars for the sweaters or the cars or whatever we’re buying, and our trading partners have the sort of obligation of either keeping those dollars and putting them under the mattress, which nobody does, [or] they can take those dollars and they can sell them and buy euros if you’re a German car manufacturer, or you can buy Chinese currency if you’re a Chinese industrialist. The third thing that they can do is they can keep the dollars, not sell them, and instead of putting them under their mattress, invest them in our securities market, which they have been more than willing to do for a long period of time.

Let’s just pretend that trade completely breaks down, right—it’s not going to happen, but let’s take the trade war to the complete nth degree. What would that mean? It would mean that we are no longer buying goods from China. It also means that China doesn’t have dollars that it will sell, so all things being equal, if that happens the dollar would be stronger rather than weaker because there’s no constant sellers of these trade-surplus countries. It also means that at the margin they’re not going to be buying our Treasury securities. And so that would mean that if all the Treasury securities were bought by domestic investors, arguably the yields would have to be higher in order to make them more attractive.

So if you put that whole situation together, that if trade goes to its nth degree, the dollar increases in value quite a bit, and interest rates go up at the same period of time. I don’t really think that that’s what the Trump policy is intending to do. But certainly the marketplace has to put some sort of a discount mechanism on that.

The way I see it, the Federal Reserve is trying to tighten financial conditions. So far, they haven’t really been successful at doing that. And I think that one could argue that’s why they continue to raise interest rates, because the other elements of financial conditions are the currency (the dollar’s not terribly strong at the moment); the equity market (which is at or near all-time highs); credit spreads (which are pretty close to all-time tights); and the interest rates in general, and while the Fed has been raising the short-term interest rates, we know there’s a lot of talk about the flattening of the yield curve. So the Fed is not particularly comfortable with that. And so they’re like, “You know what? We’re going to have to work a little bit harder.” Now, in a strange way, the trade tariffs could actually exacerbate that, right? We could get wider credit spreads, we could get higher yields, we could get a stronger dollar.

Another thing that could easily happen—the stock market goes down on the back of that. Let’s put it this way: I wouldn’t want to be short volatility going into that situation from an investment point of view.