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Trade Risks Prompt Predictions for Fed Rate Cuts

Business Maverick

Business Maverick

Trade Risks Prompt Predictions for Fed Rate Cuts

US Federal Reserve Board Chairman Jerome Powell holds a news conference after a Federal Open Market Committee meeting in Washington, DC, USA, 20 March 2019. The Federal Reserve is leaving interest rates unchanged. The federal funds rate has already been raised nine times since 2015. EPA-EFE/MICHAEL REYNOLDS

Markets rallied after Federal Reserve officials said they were closely monitoring the recent escalation in trade tensions and indicated they could respond to any economic deterioration by cutting interest rates.

“We do not know how or when these trade issues will be resolved,” Fed Chairman Jerome Powell said Tuesday. “We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion.”

Mr Powell didn’t say whether he thought a rate cut would be needed. The comments show the Fed has ended a debate over whether its next move would be to raise or lower rates and is focusing now on whether and when to cut them.

Stock markets, which were already trading higher before Mr. Powell’s comments, climbed further after he spoke. The Dow Jones Industrial Average advanced 512 points, or 2.1%, to 25332. The S&P 500 climbed 2.1%. Both benchmarks posted their biggest daily gains since Jan. 4, when Mr. Powell signalled a likely pause in rate increases.

The Fed has held its benchmark rate steady this year in a range between 2.25% and 2.5%.

President Trump has pursued tariffs and wants the Fed to lower rates. Economists and investors are projecting that uncertainty created by the administration’s actions on tariffs will prompt the Fed to deliver rate cuts later this year. So far, forecasters don’t see the Fed taking action at its June 18-19 meeting in part because they expect the central bank will want to see if global leaders can ease trade tensions, particularly at the G-20 summit in Japan later this month.

Economists at Barclays now project the Fed will reduce rates by 0.5 percentage point in September and by another 0.25 percentage point in December. Previously, the bank expected the Fed would be on hold through 2020. Similarly, economists at JPMorgan Chase are forecasting a quarter-percentage-point cut in both September and December, even if the U.S. avoids a lasting trade fight with Mexico. Until two weeks ago, the bank projected the Fed’s next move would be to raise rates, though not until late next year.

If trade frictions persist, “we could end up in a recession in three quarters,” Morgan Stanley chief economist Chetan Ahya in a report Sunday said. Recent conversations with investors “have reinforced the sense that markets are underestimating the impact of trade tensions.”

Treasury yields climbed Tuesday, with the benchmark 10-year U.S. Treasury yield advancing to 2.130%, from 2.085% a day earlier. Bond yields rise as prices fall and closed Monday at their lowest level since September 2017, with investors seeking safety in U.S. Treasurys lately.

Yields have tumbled over the past few weeks, a sign investors expect poorer growth prospects and potential rate cuts. The 10-year Treasury is down from 2.426% two weeks ago, and it now sits well below yields on three-month Treasurys, a so-called inversion of the yield curve that has often preceded rate cuts and recession.

This drop in yields indicates “the Fed is too tight,” said Marc Sumerlin of Evenflow Macro, a policy-analysis firm, in a note to clients last week. He now expects the Fed to reduce rates in July, moving forward his earlier projection of a rate cut in September.

The Fed has eight scheduled meetings a year to consider interest-rate policy. It has held three so far, leaving rates unchanged each time.

Analysts have reassessed their Fed outlooks by incorporating the reaction in bond markets to Mr Trump’s decision last week to impose tariffs on Mexico to push the country to stem Central American migration at the southern border. Senate Republicans threatened Tuesday to block the tariffs, hours after Mr. Trump indicated he was prepared to go ahead with the levies barring a last-minute deal over border security.

Bond markets have been signalling they expect the economy to slow more sharply than previously anticipated. “It feels as if the market is internalizing the fact that President Trump may not be solely focused on the health of financial markets,” said Roberto Perli, an analyst at Cornerstone Macro, in a report Monday. Mr Perli said Friday’s market expectations of the Fed’s future interest-rate path over the following eight months posted the largest one-day drop since June 2016, when British voters approved a referendum to leave the European Union. The move was larger than all but 19 other such declines since 2008, with all of those declines occurring during the financial crisis in 2008. The drop is bigger than those that occurred during a similar scare over global growth prospects in early 2016.

Others don’t yet expect the Fed to lower rates. Economists at Goldman Sachs, in a note Sunday, said they have sharply raised their odds of a rate cut, but not enough to make it their baseline forecast. “It is a close call,” they wrote.

The uncertainty reflects the Fed’s predicament. Officials have approvingly cited instances in the 1990s in which the central bank successfully reduced rates to take out “insurance” against a potential downturn. But some officials may be reluctant to make such moves in the current environment in which geopolitical surprises, not economic ones, are the main issue.

If Fed officials, for example, share Mr Ahya’s view that stock investors are underestimating the growth risks from a trade-related shock, a central-bank policy shift that sends up asset prices could exacerbate the problem. Also, trade policy has been heavily in flux over the last month. Two weeks before Mr Trump threatened to impose new tariffs on Mexico, the White House lifted steel and aluminium tariffs on Canada and Mexico in a bid to smooth passage of a recently completed North American trade deal.

“By reacting, the Fed risks incenting the same volatility it is trying to quell,” Tom Porcelli, chief U.S. economist at RBC Capital Markets, said on Monday.

Dallas Fed President Robert Kaplan said the speed with which trade tensions have escalated suggests there is the potential for a similarly speedy resolution. “I want to take a little bit more time and be patient here because some of these recent events could be reversed,” Mr Kaplan said in an interview in Chicago. “We’re very cognizant of these downside risks and very cognizant of the change in the shape of the yield curve,” he added. “The only reason I’m not suggesting a specific action yet is it’s very recent.”

Likewise, Fed Vice Chairman Richard Clarida said it was too soon to judge how the Fed would react to any trade-related shocks. “We would confront that when we get to it,” he said Tuesday on CNBC. “We will put in policies that need to be in place to keep the economy, which is in a very good place right now, and it’s our job to keep it there.”

So far, only one Fed official has said the central bank should cut rates. St. Louis Fed President James Bullard said the inverted yield curve and a perceived shift in the Trump administration’s prospects to achieve near-term trade agreements warranted the move. “The narrative on global trade has darkened,” he said.

“Monetary policy looks too restrictive in this environment,” he said, referring to the inverted yield curve. “That’s usually been a bad sign for U.S. economic prospects.”

Fed officials have already demonstrated a willingness this year to shift policy to defuse looming economic threats, as they did in January when they shelved plans to raise rates this year.

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