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.

'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.

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