NO DEAL, BUT NO ESCALATION: Why CBA expects the US-China trade deadline will be extended

* Since 2005, whenever financial markets have priced in RBA rate cuts, the bank has usually delivered -- eventually. * As things currently stand, a 25 basis point rate cut is still fully priced by the middle of next year. * ANZ Bank says the "hurdle for a rate cut remains fairly high" and would require a "sustained deterioration in the labour market and step-down in consumption growth". * ANZ sees the RBA cash rate remaining unchanged at 1.5% until the second half of next year. The cash rate has been at its current level since August 2016.* * *When financial markets begin to price in rate cuts from the Reserve Bank of Australia (RBA), the bank almost always cuts rates -- eventually. This chart from ANZ Bank shows the differential in market pricing for the cash rate looking around 18 months ahead compared to the actual level of the cash rate since 2006.More often than not over this period, when the market moves to price in additional easing, the RBA almost always will oblige. "Since 2005, in almost all instance in which markets have started pricing cuts aggressively, the RBA has eventually cut," says ANZ's Australian economics team, led by David Plank."However, the lag between the market first pricing a cut and it happening has been quite variable. "In the most recent instance, when the RBA cute from 2% to 1.75% in 2016, there was a lag of 300 days."So the RBA usually moves the cash rate lower when markets have already began to price in the likelihood of further easing, although the reaction function from the bank is not always immediate.While financial markets pared back collective expectations for additional easing late last week, a full 25 basis point cut is still priced for delivery by the middle of next year.Despite the recent track record, ANZ says those in markets anticipating a 25 basis point cut during this period may end up being disappointed."The front-end rallied sharply following the RBA’s move towards a neutral policy outlook," ANZ says, referring to market move following the RBA's admission that the next move in the cash rate now appears to be "evenly balanced"."Our view is that these moves are an overly dovish interpretation of the RBA, although not to an extreme extent. "The hurdle for a rate cut remains fairly high and would require a sustained deterioration in the labour market and step-down in consumption growth. "We struggle to see this happening by the time of the RBA’s May forecast update."Currently, ANZ expects the cash rate will remain steady at 1.5% until the middle of next year, in line with the vast majority of economic forecasters polled by Bloomberg.Of those expecting a move over this period, most are anticipating, like markets, that the next move will be lower.Australia will receive a double-dose of important labour market indicators this week, starting with the December quarter Wage Price Index. That will be followed on Thursday by labour force data for January.Both releases carry the potential to shift market expectations for the cash rate in the months ahead.

• The trade war between China and the US has now been underway for nearly a year.

• An escalation in the conflict could occur should a trade deal between the two sides not be agreed by March 1.

• The US has promised to broaden and increase tariffs on all Chinese imports entering the country should no deal be struck by the time the deadline lapses.

• With negotiations between the two sides seemingly inching towards a deal, the Commonwealth Bank says the odds of this deadline being extended have increased.

Unless a trade deal can be struck by March 1, the US government says it will broaden and increase tariffs on all Chinese imports entering the country, escalating the trade war that's now been underway for close to a year.

Such a scenario would be a dangerous and unwelcome development for the global economy, especially as there's clear evidence that a slowdown in activity is already underway.

Kevin Xie, Fixed Income Quantitative Strategist at the Commonwealth Bank, says an escalation in the trade war is unlikely to take place, albeit with a very big caveat: China's government will need to satisfy US officials that it will deliver on its promises.

"There are reasons to be tentatively optimistic about the prospects of a prolonged trade truce between the US and China," Xie says.

"The Chinese government has already committed to purchasing a substantial amount of US agricultural and energy products. The Chinese government is also taking steps to address US claims on forced technology transfer, non-tariff market access barriers and intellectual property protection issues."

These are all attempts to appease concerns raised by the US government, and have been cautiously welcomed by officials, including Donald Trump, but Xie says that an actual concrete trade deal between the two sides is unlikely to arrive before the hard deadline on the next round of US tariffs kicks-in at the start of March, meaning the odds of a continuation of the status quo are firming.

"In light of recent developments, we consider the current trade truce is likely to be extended beyond the current deadline. In our view, both sides will need more time to reach a compromise," Xie says.

"However, trade negotiations are unlikely to be a smooth journey because the two sides remain divided on certain topics."

In particular, Xie says China's plan to become a global powerhouse in advanced manufacturing, known as the "Made in China 2025" plan, will be a major sticking point in negotiations between the two sides.

"The US is demanding the complete abandonment of the Chinese government’s 'Made in China 2025' (MIC) plan because it is perceived as a threat to the US’s technology position," he says.

"China has downplayed the MIC plan but has not scrapped it.

"The statement following China's annual Central Economic Work Conference stated upgrading manufacturing capability was a key policy initiative... [given it's seen as a] means of escaping the 'middle income trap'."

With negotiations between China and the US seemingly inching towards a deal, and with concerns about a possible escalation in the trade conflict still lurking beneath the surface, raising the potential for renewed weakness in financial markets, Xie says a postponement of the March 1 deadline will not only allow for further time for negotiation but also for US officials to examine whether China is following through with promises already made.

"The US continues to demand structural changes from the Chinese government. However, in our view, there is a change in focus," he says.

"The demand for ongoing monitoring and verification indicates the US is cautious whether the Chinese government can deliver on its promises."

As things currently stand, the US has implemented tariffs of between 10% to 25% on $US250 billion worth of Chinese goods entering the country. In retaliation, China has introduced reciprocal tariffs on $US110 billion worth of US goods imports.

In December, the tit-for-tat tariff tiff between the two nations came home to roost in China's trade report with the value of imports and exports both falling by the most in year-ended terms since the second half of 2016.