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Trump's trade war with China is starting to get out of hand

New York(CNN Business) The US-China trade war has always been serious. Now it's starting to get scary.

China allowed its currency to drop sharply on Monday to the weakest level in more than a decade. And China announced its companies have halted purchases of American agricultural goods.

The Trump administration escalated tensions even further late Monday by taking the historic step of labeling China a currency manipulator. This comes after US President Donald Trump vowed last week to impose tariffs for the first time on a wide swath of US consumer goods from China.

The trade conflict has reached a new level of seriousness that will be difficult to reverse. The risk is that the trade war is approaching the point at which it causes a severe economic slowdown or even a recession.

By digging into their positions, both the United States and China increase the risk of breaking an economy that is already starting to crack. Each round of escalation gets them closer to a recession — and to a point of no return.

"We have a trade situation that is going off the rails," Peter Boockvar, chief investment officer at Bleakley Advisory Group, wrote in a note to clients on Monday. "The policy of using tariffs as a tool to address our legitimate beefs with the Chinese has failed miserably."

David Kotok, co-founder and chief investment officer of investment firm Cumberland Advisors, told CNN Business that "this stupid tariff war we're having" is raising the risk of a recession.

"Things are escalating and the escalation is not over," Kotok said.

The sense that the trade war has entered a new and more dangerous phase was confirmed when the US Treasury Department officially designated China as a currency manipulator. The news prompted further selling in global financial markets and raised speculation that China could take even more aggressive steps to devalue its currency.

"It makes things worse," said Ian Winer, advisory board member at Drexel Hamilton. "If people thought they kept the yuan from weakening to avoid being labeled a currency manipulator, that just went out the window."

Trade war fatigue

Investors around the world are spooked.

The Dow plunged 767 points, or 2.9%, on Monday. The Nasdaq tumbled 3.5%, suffering its longest daily losing streak since just before Trump's 2016 election. The VIX (VIX) volatility index spiked 40% to a seven-month high.

Investors piled into government bonds, driving the 10-year Treasury yield to 1.75%, the lowest level in nearly three years.

"The escalating US-China trade war will certainly be bad for the US economy. How bad is almost impossible to calculate," said Art Hogan, chief market strategist at National Securities Corporation.

Hogan said that the worse the trade war gets, the faster a recession could arrive in the United States.

"Historically, recessions occur in reaction to a monetary policy mistake. This is the first time we may have to deal with a trade policy miscalculation," he said.

Many investors and business executives broadly agree with the Trump administration's desire to get China to play fair on trade. Beijing's non-tariff trade barriers, including forced technology transfers, have long hurt American businesses.

However, there is growing concern about Trump's use of tariffs as a way of getting concessions.

Next round of tariffs will hit consumers

Trump blindsided Wall Street last week by announcing plans to impose a 10% tariff on $300 billion of US imports from China.

The new tariffs, which are scheduled to go into effect on September 1, would target everything from apparel and footwear to electronics such as smartphones. More than previous rounds of tariffs that shielded finished goods, these levies would hit US households, the strength of the American economy.

"If you inject uncertainty during back-to-school and holiday shopping, that will have a drag on the economy," Hogan said.

Retail and tech stocks have been hit especially hard by the latest tariff threat. Best Buy (BBY) alone has plunged nearly 15% since Wednesday's close.

The Chamber of Commerce warned last week that these new tariffs "will only inflict greater pain on American businesses, farmers, workers and consumers, and undermine an otherwise strong US economy."

America's farmers won't get relief any time soon. China's Commerce Ministry confirmed that Chinese companies have halted purchases of US agricultural products.

The trade war has forced Washington to come to the rescue of farmers with billions of dollars in aid. Delinquencies on agriculture loans have tripled since mid-2015 to eight-year highs, according to the St. Louis Federal Reserve Bank.

FDIC Chairman Jelena McWilliams told CNN Business last week that the agency is "monitoring very closely" how banks in farm states are being impacted by the trade war.

"We may experience more delinquencies, which then become very difficult for those communities and our ag sector," McWilliams said.

Currency war fears

China retaliated on Monday by allowing the yuan to move above the psychologically important ratio of 7 to 1 against the US dollar. The People's Bank of China blamed the weakness on "trade protectionism and new tariffs on China."

"China retaliates: on a scale of 1-10, it's an 11," Chris Krueger, senior policy analyst at the Cowen Washington Research Group, wrote in a note to clients.

Hours later, Trump responded on Twitter, calling the move "currency manipulation" and a "major violation which will greatly weaken China over time."

The fact that China decided not to defend its currency further suggests Beijing is digging in for a longer trade war. Officials are no longer trying to avoid Trump's currency wrath.

"China is taking a darker and more cynical view of Trump's objectives with China," said Michael Hirson, Eurasia Group's practice head of China and Northeast Asia. "They're becoming increasingly pessimistic about their ability to steer Trump away from further escalation."

China's currency move raised the specter of a currency war, where major countries race to devalue their respective currencies.

"It's the currency risk that is the most volatile, hardest to see and the fastest reacting," said Kotok. "That's the left hook that can knock out the boxer."

Nervous investors flocked to gold, driving the precious metal above $1,460 an ounce for the first time since May 2013.

However, Hirson said China is "not weaponizing its currency." Rather, he argued officials in Beijing are trying to take ownership for a decision they would have needed to make eventually.

And there are powerful incentives preventing China from allowing its currency to sharply devalue. Such a move would panic investors, destabilize financial markets and trigger a wave of foreign capital that Beijing has been desperately trying to attract.

Can the Fed offset the trade war?

The problem is that this trade war escalation is occurring against a backdrop of cracks in the global economy. China's growth has already slowed. Manufacturing surveys around the world have tumbled.

US factory activity in July decelerated to the weakest level in nearly three years. A closely watched gauge of US service sector activity declined on Monday to a level unseen since August 2016.

And global central banks don't have much room to offset economic turmoil. Borrowing costs are already extremely cheap. Lowering them further won't directly offset trade uncertainty.

Europe and Japan's central banks still have negative interest rates. The Federal Reserve has already done a sudden reversal from hawkish to dovish. Last week, the Fed cut interest rates for the first time in nearly 11 years.

"Central banks are running out of bullets," said Kotok.

Morgan Stanley warns of 10% retreat

That's why Morgan Stanley on Monday said it has "high conviction" US stocks will experience a 10% correction before the end of September. The S&P 500 is already about halfway there.

The trade war and Fed developments have opened markets up to a "meaningful downside based on the deteriorating fundamentals that can no longer be ignored," Michael Wilson, Morgan Stanley's chief US equity strategist, wrote in a note to clients.

Of course, the market pain could force Washington and Beijing to reverse course.

Trump closely follows financial markets and does not want to get blamed for ending the longest bull market in American history.

But Hirson suggested China and the United States remain stuck in an escalatory feedback loop.

"The more Trump increases pressure on China," he said, "the more difficult it becomes for the leadership there to back down because that makes it look like they are negotiating at gunpoint."

In other words, the trade war looks likely to get worse before it gets better.

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