For the first time in a decade, the Fed cut interest rates last Wednesday by lowering the US benchmark rate by 25 basis points. They also decided to end quantitative tightening, or the process of reducing the amount of bonds held on its balance sheet, in August - two months earlier than planned. These moves will lower borrowing costs and support financial conditions, which will help sustain the economic expansion and boost inflation.
Why did the Fed believe this was necessary?
Fed chairman Jerome Powell stated at his press conference, that despite what the Fed views to be a favourable outlook for the US economy, it is cautious of the growth risks posed by global trade uncertainties. The Fed is also cautious of how persistently weak inflation could lead to a scenario where long-term inflation expectations become depressed, which would be hard to get out of.
More importantly, the Fed now favours a pre-emptive approach towards insuring the economy against uncertainties. This means cutting rates early when they see credible risks, and not waiting until full-blown troubles emerge. Considering that interest rates are now at very low levels versus historical standards, this approach makes some sense: there might not be sufficient room for conventional rate cuts to save the economy if they act too late.
In this context, Powell took pains to clarify that the rate cut last week is “not the beginning of a long series of rate cuts” but a short “mid-cycle adjustment” in order to insure against downside risks. Powell’s characterisation of this cut, together with a lack of pre-commitment to another cut in September, opens up options for the Fed in pondering its next move.
Powell is also gently pushing back against aggressive market expectations of future Fed cuts. Before the Fed meeting last week, the futures market was pricing in as much as a full percentage point decline in the US benchmark rate by end 2020, and some investors were expecting a 50-basis point cut in July alone.
Disappointed that the Fed did not sound as dovish as anticipated, the markets sold off after the meeting. Given how aggressive market expectations had become, some recalibration of pricing was perhaps inevitable, but overall, we think that investors might not be way off the mark to expect two or more 25-basis point cuts ahead.
It is hard to see why the Fed would do a “one-and-done” since a single 25-basis point cut alone would not offer much insurance at all. In addition, in the last two “mid-cycle adjustments” that took place over 1995-6 and 1998, the Fed cut rates by a total of 75 basis points in each case. This does not deviate too much from market expectations today.
The Fed has consistently cited weakness in business investments and low inflation as justification for its policy moves. By implication, these will be the two areas to watch in the coming months to see if the Fed would cut further, which seems likely to be the case today.
The main headwind for business investments today is global trade friction, both real and threatened, between the US and its trading partners, including China, Mexico, Europe and others. Trade fear is negatively impacting business confidence in the manufacturing sector, and consequently suppressing investment spending which is an important driver of economic growth.
One established gauge of business sentiment is the purchasing manager index (PMI), which is a comprehensive business survey and historically a leading indicator for economic growth. Manufacturing PMIs across major economies have been weak over 2019 to date and continue to falter. The figures in the US and Eurozone are at their lowest since 2012. In China, despite a concerted effort by policy-makers to stimulate its economy, the manufacturing PMI again slipped below 50 – a level which signals contraction – in June.
For investors, US-centric trade friction lies at the heart of uncertainties. With President Trump in the White House, the Fed is no longer the only game in town. Looking ahead, the markets will need to navigate two opposing forces: escalating trade uncertainties driven by Trump’s political agenda versus the relief from a global monetary policy easing cycle led by the Fed.
It will be a tug of war. Right after the Fed cut last week, Trump surprised the market by announcing 10% tariffs on the remaining US$300b of Chinese imports with effect from September 1. This round of tariffs is anticipated to exert more economic harm than previous sets. To make things worse, this will hit the consumer sector just before US importers place orders for the important year-end holiday season.
With trade uncertainties mounting, our baseline scenario is that the Fed will cut rates by another 25 basis points in September, with a third cut likely to follow. As other central banks follow the Fed’s lead, the global monetary policy easing cycle will broaden over the next few months, but this would only partially offset the damage from Trump’s trade war, which is escalating in intensity and breadth.
Investors should be prepared for turbulent markets ahead.Disclaimer applicable to recommendation
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