As far as the market is concerned, the Jerome Powell put is back in play and now the real question is how quickly will it be exhausted by trade war tweets and economic gloom?
On Tuesday, stocks posted the biggest one day rally since January on the heels of Powell’s three-sentence reference to being “prepared to act as appropriate to sustain the expansion”. Stocks soared and US 2Y yields plunged as rate cut bets immediately flooded the tape.
However, while bulls might look at Powell’s statement as a nice reprieve for markets, the question will soon shift to whether or not the Fed has enough ammo? With the upper bound of the policy rate at 2.50%, there’s substantially less conventional Fed firepower than in previous economic slowdowns. When the financial crisis hit in 2008, the rate was at 5.25%.
So while short-term rates & Eurodollar spreads are pricing in roughly ~50bps of easing by year-end, it’s not entirely clear that delivering two 25bp rate cuts will be sufficient to offset the impact of 25% tariffs being proposed for most goods from China and Mexico -- the top-two exporters to the U.S. -- by October. Perhaps more importantly, what would a 50bp cut do for risk sentiment while a trade war looms in the background?
There’s also the psychological dilemma of what perceived or actual rate cuts might do to alter trade war rhetoric. Some are worried that cutting rates risks a scenario where the White House is emboldened to press ahead with more tariffs knowing that the central bank is effectively providing cover. More tariffs presents further upside risk to inflation and more downside risk to growth, meaning that paradoxically, were the Fed to cut now in an effort to head off a trade-related downturn, it could end up making things immeasurably worse if a rate cut ends up being viewed by the administration as a green light to escalate the trade war. Here’s an excerpt from Deutsche Bank:
An overly accommodative Fed could encourage further escalation of trade wars with more tariffs on one side and, at the same time, erode Fed’s credibility on the other. Further trade war escalation would act as a negative supply shock causing a higher price level ultimately forcing the US consumer to carry the costs of higher tariffs. In this way, temporary stock market stability becomes destabilizing with the economy suffering from higher inflation and lower output which does not have a proper monetary policy response.
Why is all of this important? It’s important because the bond market is directly at odds with the stock market in regards to the global economic outlook. Bonds have gone from pricing in a “growth scare” to now an “outright recession”. This can be seen in the US treasury curve where the short end has collapsed due investors aggressively snatching up shorter duration bonds, which has caused the curve to steepen.
So if the market is now positioned for a recession / disinflationary shock, then what’s the risk moving forward? Well according to Nomura, it’s stagflation...
Despite this obvious “end-of-cycle growth scare escalating into recession” bullish catalyst for the crowded “Receiving Rates / Long Duration / USTs” trade & hedge, there is simultaneously the growing risk of an “inflation impulse” NEGATIVE shock to the trade, via the cumulative impact of 1) the *expected* fourth tranche of China tariffs on top of the prior announced tariff impact and 2) the *assumed* full-impact of the Mexican tariffs (going all the way to 25%) which per Lew Alexander’s US Econ team would add upwards of an additional +0.75 to US Core PCE by 1Q20—setting-up the potential for a “stagflation-lite” type of environment
Why did Nomura suddenly reassess that stagflation is the biggest risk? They cite new academic research published recently by the NY Fed's economic blog, showing a nearly 100% pass-through of the 2018 tariff costs into domestic prices of imports, to wit:
“The magnitude of these costs depends on how a tariff affects the prices charged by foreign exporters and the U.S. demand for imported goods. Studies, including our own, have found that the tariffs that the United States imposed in 2018 have had complete pass-through into domestic prices of imports, which means that Chinese exporters did not reduce their prices. Hence, U.S. domestic prices at the border have risen one for-one with the tariffs levied in that year. Our study also found that a 10 percent tariff reduced import demand by 43 percent.”
Basically, the Fed could end up being relatively constrained in the sense that theycannot cut to the same extent which the market is attempting to price, due to the Committee’s awareness of the impact that the tariffs will have on import prices.
Anyway, as research firms debate over 2019 FOMC forecasts, BAML reminds us of what’s happened in the past: the last three recessions all took place with 3 months of the first rate cut after a hiking cycle.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.