Federal Reserve Chairman Jerome Powell. Source: New York Times
Financial markets continue to levitate, regardless of corporate earnings. Markets bounced Tuesday after Fed Chairman Jerome Powell intimated the Fed could cut rates if the trade war intensifies. Below is a synopsis of Powell's comments and my interpretation.
“We do not know how or when these issues will be resolved,” he said, in remarks that helped stoke a powerful rally on Wall Street. “We are closely monitoring the implications of these developments for the US economic outlook.”
Over the past few months, Powell's comments have been all over the place. The Fed hiked rates by a quarter point in December and intimated more rate hikes could lie ahead. At its March 2019 FOMC meeting, the Fed appeared to change course, implying rates could shift in either direction. At the time, the March jobs report showed low unemployment and wage growth that exceeded 3%. Wage growth implied the economy was strong, yet other metrics suggested otherwise.
Growth in personal consumption expenditures ("PCE") in March was 1.6%, less than the 2.0% range targeted by the Fed. Even more alarming was that the yield curve inverted in March. An inverted yield curve's ability to predict recessions implied the economy may not have been on strong footing. I believe this is really what prompted the Fed to become more open on its rate policy.
If the economy was weak in March, then an escalating trade war with China (and potentially with Mexico) will likely not help matters. First of all, nobody wins in a trade war. Secondly, tariffs on Chinese goods could increase the cost of those goods, creating an inflationary effect. Rising costs amid a low labor participation rate would not be good for the U.S. Lastly, if China places tariffs on U.S. goods, then our products may be more expensive in China vis-a-vis those of other countries. This could reduce China's purchases of U.S. goods, slowing our economy even further. It would be more than prudent for the Fed to monitor this situation.
Referring to tariffs, which in the past month have been raised on imports from China and threatened on imports from Mexico, he said that the Fed would “act as appropriate to sustain the expansion, with a strong labour market and inflation near our symmetric 2 percent objective”.
In the urban dictionary, "finesse" means to "Take something from another person in a slick way." In early May, President Trump took to Twitter to imply he would impose tariffs on additional Chinese goods. Financial markets faltered on May 10th just after his tweets.
The President and his economic advisor, Larry Kudlow, have also talked up the need for Powell to cut interest rates to spur the economy. Less than a month after President Trump's tweets about more tariffs on Chinese goods, Powell is now open to a rate cut. Is this a coincidence, or is President Trump trying to finesse a rate cut out of Powell?
There is a school of thought that President Trump needs a strong stock market heading into the 2020 presidential election. After several years of the Fed driving down interest rates and adding liquidity to financial markets, PCE growth is anemic and signals of a recession abound. These actions have caused a spike in asset prices such as real estate and stocks. If the president cannot spur the economy, then maybe higher stock prices will be enough to give the "illusion" of growth and get him re-elected.
That is where Powell comes in. President Trump may need Powell to cut rates or reduce the unwind of the Fed's trillion dollar balance sheet. The rub is that the trade war with China could potentially be settled by the end of the summer if the two parties negotiate in earnest. Undoing a rate cut could be much more difficult. President Trump and Kudlow will likely push the Fed to wait until PCE growth exceeds 2.0% for an extended period before hiking rates again. That may not happen anytime soon.
President Trump is right about China pirating U.S. software. It is commendable of him to stand up to China on the matter. However, I do not believe the issue needs to lead to a trade war. The trade war talk appears to be saber rattling. If the president got (1) China to agree to stop pirating our software and (2) Powell to cut rates and provide more fuel for stocks, then his reelection could be all but assured.
I believe the economy has peaked. Another rate cut may not help the situation, but it could drive stocks higher. I expect more volatility due to chatter over trade wars and interest rate cuts. However, investors should continue to avoid cyclical stocks and highly-indebted names.
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