For several months all was working well. Or so it seemed. Slowly ratcheting up trade tariffs on China gave President Trump several talking (and tweeting) points with minimal economic blowback. US growth slowed, but only modestly and in any case it wasn’t obvious that the trade war was to blame. But the game may have changed on Monday, when China let its currency fall below rise above a psychologically key red line: 7 to the US dollar, marking the lowest point in more than a decade for the yuan.

The simmering trade battle looks set to be joined by a currency war—a one-two punch that will create stronger headwinds for the global economy. Further stoking the potential for macro risk: yesterday’s announcement by the US Treasury, which officially labeled China as a currency manipulator. It’s a largely symbolic move, but it “marks the start of a process that may end in the Trump administration attempting to devalue the dollar,” says Joe Brusuelas, chief economist at RSM.

Fighting China on a two-front economic war may yield political benefits for Trump in terms of his base, but the president’s claim that “trade wars are good, and easy to win” looks increasingly misguided. The main challenge: China’s economy is too big and its government too proud to give Trump a clear victory any time soon if ever with his usual tactics of threatening tweets.

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“The Chinese have sent a strong signal that they are ready to rumble,” advises Paul Blustein, a senior fellow at the Centre for International Governance Innovation. “To depreciate the currency at such a fraught time sends a signal that they are prepared to endure a heck of a lot of pain, and it doesn’t surprise me that markets would finally come around and say, ‘This could be really bad.’”

Yet Trump isn’t likely to blink and so the potential for a stalemate appears likely. As economist Paul Krugman notes, “What may have looked like temporary tariffs designed to win concessions now look like permanent features of the world economy, with the level of tariffs and the range of countries facing them likely to expand over time.”

Julian Evans-Pritchard, senior China economist at Capital Economics, agrees. “The fact that they [China] have now stopped defending 7 against the dollar suggests that they have all but abandoned hopes for a trade deal with the US,” he tells CNN.

Whatever the political and economic implications, recent events have reordered expectations in financial markets. Notably, the appetite for safety has surged, as reflected by the sharp slide in the 10-year Treasury yield (which moves inversely with bond prices). The rate on the world’s favorite safe-haven benchmark fell to 1.75% on Monday (Aug. 5), the lowest in nearly three years.

Stocks, on the other hand, have tumbled recently, including yesterday’s sharp 3% plunge in the S&P 500. Although the sharp runup in equities earlier in the year left the market vulnerable, the recent decline reflects growing concern that the relationship between the world’s two largest economies looks set to deteriorate further in the months ahead.

It’s anyone’s guess how this plays out, but the economic risks are surely edging higher—on multiple fronts. One example: inflation, or rather the lack thereof. The Federal Reserve has been increasingly focused on the subdued pricing pressure in the US economy and the latest flare-up in the US-China trade war may exacerbate that risk. Indeed, the implied inflation outlook tumbled in recent days via the yield spread on nominal less inflation-indexed Treasuries. For the 5-year maturity, the crowd repriced the inflation forecast down to 1.39% on Monday—the lowest in three years and well below the Fed’s 2% inflation target.

Next year’s US elections had been seen as a possible force to incentivize Trump to work with China to find common ground, possibly offering the president bragging rights that he engineered a solution to the trade conflict. But the White House’s increasingly hardline policy decisions on trade are changing the outlook. “While we had previously assumed that President Trump would see making a deal as more advantageous to his 2020 re-election prospects, we are now less confident that this is his view,” advise analysts at Goldman Sachs.

Trump’s mercurial personality may yet surprise everyone by adopting a more conciliatory posture toward China, although recent events suggest otherwise. In any case, the US, China and the world economy have reached a dangerous juncture. The good news is that global growth is still positive, although just barely, according to the JP Morgan Global Composite PMI for July. The mildly positive trend, however, is due primarily to the services sector. Manufacturing, by contrast is contracting on a global basis.

A similar story applies to the US. Growth picked up in July via the US Composite PMI, signaling a modest pace. “But the overall weak pace of expansion remains a concern,” says Chris Williamson, chief business economist at IHS Markit, which publishes the PMI survey data. “The PMIs for manufacturing and services collectively point to GDP expanding at an annualized rate of under 2% in July, below that seen in the second quarter and among the weakest seen over the past three years.”

Recession risk may be rising, but it’s not yet fate. A resolution (or even a partial resolution) to the US-China trade dispute would raise animal spirits and provide a boost to economic activity. But it’s not obvious that Trump is inclined to negotiate and so for the time being the most reliable forecast is more of the same—a disinflationary/deflationary economic wind that will continue to strengthen until or if political leadership – from the US or China – emerges to change the trajectory.

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