The US Federal Open Market Committee (FOMC) this week met market expectations by cutting the policy rate form 2.50% to 2.25%. Moreover, quantitative tightening (QT), which is the shrinking of the Fed’s balance sheet, ended on 1 August – two months earlier than announced in March.
One would think that this was a welcome development, but the markets were disappointed. It was seen as a hawkish cut: the tone of the statement, the post-meeting press conference and Q&A, and the fact that two of the FOMC members voted for rates to stay unchanged led to weaker risk markets and renewed flattening in the UST curve. The press conference, in our view, revealed that the Fed is not overly concerned about growth and that this was a reluctant cut in the face of significant political and market pressures.
Traders and investors are now somewhat confused as Powell has not obviously signalled imminent further easing, nor has he ruled out further cuts. He has implied that we are facing a similar situation to 1995 and 1998 when the Fed delivered modest insurance rate cuts (75bp in total off a higher base in each case). The market was probably overly optimistic with regard to the pace and quantum of cuts. To be sure, it is not obvious from US real activity data, credit growth, and the performance in the equity market that massive monetary stimulus is needed now. We think the Fed correctly walked back markets from being overly optimistic on rate cuts.
While some are sounding the alarm on an imminent recession as justification for aggressive rate cuts, others note that monetary stimulus is needed to increase inflation. Rather, low inflation is giving the Fed room to ease as opposed to being the trigger. It is difficult to demand cyclical rate cuts to boost inflation when the drivers of inflation have structurally changed away from the traditional cyclical factors (for various reasons such as globalisation, demographics, and lower unionisation).
Irrespective of the theoretical rationale for lower rates, in the end of it is about the equity market. If the S&P sell-off intensifies, the market will again price in aggressive Fed cuts and Powell will again be backed into a corner.
Trump, via Twitter, bemoaned the small rate cut saying “As usual, Powell let us down” and that he was not “getting much help from the Federal Reserve” to Make America Great Again. In response to the Fed not fully following the dovish market, Trump has announced 10% tariffs on the remainder of imports (c.US$300bn) from China, effective 1 September. This has reportedly come as a big surprise to Chinese officials, given that the trade talks were not falling apart, and in turn, they have threatened retaliatory measures. On the morning of 1 August, the Fed Fund futures curve was assigning a 62% probability to a September rate cut. As we go to print, the chances have shot up to 100%.
Therefore, in weakening the equity market, Trump’s actions may very well force the Fed to cut as early as September. Lower interest rates and the resultant (hoped for) dollar weakness would buttress US growth and boost equities. The caveat here is that exchange rates are relative prices and the other side of the dollar coin would require that Europe and Japan lag the US in policy easing. On this score, the ECB’s forward guidance in June has all but guaranteed deeper negative rates and renewed quantitative easing in September. Hence, if the Fed does not follow through with early cuts, then the dollar will remain firmer for longer, posting a headwind to US earnings, global growth, and US inflation. Ultimately, this will lead to Fed easing.
The issue is one of timing and conspiracy theories. It is difficult to discern the true motives for the trade wars. Many believe it is a fundamental Washington hard-line position against China. Others view it as a tactical strategy by Trump to ensure his re-election in the 2020 US presidential election. In fighting with China (and potentially Europe and Japan), he lowers the 2019 base for a strong growth and equity market rebound in 2020. Moreover, he has the option to deliver the trade deal of a lifetime at the height of electioneering.
What Trump might not appreciate is that the ramifications of trade tariffs and attendant uncertainty are potentially long lasting and that trade tariffs are not a zero-sum game. If international trade has been a positive-sum game, reversing that would more likely be a negative-sum game.
An often-cited quote is that it is difficult to make predictions, especially about the future. This is all the more so when you have to factor for Trump and his tweets.
For now, the combination of renewed trade tariff uncertainty and the not-so-dovish Fed will make it difficult for risk assets to rally and raise the hurdle for the South African Reserve Bank (SARB) to cut rates soon. The SARB has perfected the art of a hawkish cut – as shown in at the July MPC meeting. Therefore, we might have to wait a bit longer for our mortgages to become cheaper. After all, the SARB will be following the Fed, in either direction.