Forget a hawkish hold when Tariff Man ups the ante

Forget a hawkish hold when Tariff Man ups the ante

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Following what had been dubbed a “hawkish” rate cut by the US Federal Reserve, Tariff Man appears to have swooped in to force chairman Jay Powell’s hand as the president clearly wants a bigger cut.

There were two catalysts for Thursday’s dramatic market action on Wall Street and they both reflect the damage being inflicted by trade protectionism.

First, US manufacturing data highlighted slowing activity. Here was a case of bad news soothing equity and bond markets after Mr Powell ruffled a few feathers during his press conference on Wednesday. 

The ISM purchasing managers’ index from the sector arrived at 51.2, a level previously seen in late 2016, which missed expectations of a 52 reading. While the US has yet to follow other leading countries below a reading of 50, which marks contraction territory, the tepid data spurred a rally in both government bonds and equities, while oil prices fell sharply on global manufacturing woes. 

The S&P 500 index had pretty much erased its post-Powell sell-off from Wednesday afternoon, only to crumble when President Donald Trump said the US would slap a 10 per cent tariff on $300bn of Chinese goods from the start of September aside from the $25bn of goods that already have a 25 per cent levy. Clearly Mr Trump is upping the pressure on China, with the view that the economic blowback will merit further easing from the Fed and a weaker dollar. 

Ian Lyngen at BMO Capital Markets says Mr Trump’s threat places the Fed chair in a tricky spot: He says:

“Regardless of the Fed’s thinking on the pace or likelihood of a second cut yesterday, unless there is unbelievable progress made on the trade front which takes the looming 10% bump off the table, the three consecutive quarter-point scenario (comparable to the 1990s) is suddenly much more reasonable as a baseline assumption.”

Mr Trump’s warning also leaves investors having to figure out his endgame. Steve Englander at Standard Chartered says:

“The question for investors is whether this is the first step in a series of escalations or a negotiating stance that will compel China to make concessions and the Fed to ease.”

He adds:

“A risk for investors is that asset-market effects would be largely reversed if the tariff increase were delayed or cancelled. If the president can elicit concessions from both China and the Fed, it would be a double win from his perspective.”

What was already an impressive looking rally in Treasury paper then simply ignited. Meanwhile, the S&P 500 sank 1.4 per cent from its day high, oil extended its losses and the dollar index turned negative after earlier climbing to its best level in more than two years.

The policy-sensitive two-year Treasury note fell to a low of 1.70 per cent, having traded as high as 1.96 per cent less than 24 hours ago, when Mr Powell spoke. That’s the lowest level seen for two-year yields since November of 2017. As for the 10-year yield, it simply sliced through 1.90 per cent, setting a new low for the year and traded at a level not seen since November 2016. Inflation expectations also tumbled. 

Clearly, a lot of bearish Treasury positions established as Mr Powell spoke yesterday have simply been liquidated — and quickly given the speed and scale of the move in Treasury yields. The futures market is once more making the case for another two rate cuts this year. The January 2020 fed funds futures contract implies a rate of 1.63 per cent, versus the current mid-rate of 2.125 per cent, not too shy of expectations around 1.58 per cent seen in late June.

The tone of Friday’s US employment report for July is the next big data event — 165,000 job gains are forecast after a 224,000 rise in June with average hourly earnings for the past year seen steady at 3.1 per cent.

So “turnaround Thursday” may face a Friday test, but the latest salvo in the trade war between Beijing and Washington makes Mr Powell’s task of steering a prudent policy course that much harder. 

As John Brady at RJ O’Brien says:

“This ‘mid-cycle rate adjustment’ was never about the growth data. It is about inflation, inflation expectations, the trajectory of inflation, and the risks to slowing global growth. China-trade and Brexit seem to be immediate challenges ahead for the global economy.”

This sets the stage for a test of wills between the markets, the Fed and other central banks over the coming weeks. 

Oliver Jones at Capital Economics notes:

“Overall there has been a sense that policymakers are shifting gradually towards looser policy, rather than rapidly changing their position in a bid to get well ahead of the curve.”

This ratcheting up of trade tension reduces the prospect of the global economy finding a higher gear given the pronounced drop in bond yields seen so far this year. But before the latest trade development there were many who thought central banks would vindicate the bond market’s easing path. 

Andrew Mulliner, portfolio manager at Janus Henderson Investors, says no matter the Fed’s desire not to signal it will follow the bond market’s easing path, this is likely to happen “as the steady deterioration in the business surveys feed into weaker US economic data”. In turn, that leaves investors facing a further decline in bond yields, while “equities and credit spreads are vulnerable”, adds Mr Mulliner. 

Quick Hits — What’s on the markets radar

Bank of England holds fast — A higher inflation forecast and a weaker growth outlook was Thursday’s message from the BoE in a policy meeting overshadowed by Brexit. 

Oliver Blackbourn at Janus Henderson Investors says:

“The Bank continues to find itself entangled in a web of planning for ‘no deal’ but being unable to use this as an assumption in its own forecasts. This is creating significant inconsistencies between its outlook and the market forecasts that feed into it.”

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