• The Fed is not done cutting rates

• Additional rate cut may be necessary if US-China trade war persists

• Door for PBOC cut opens with trade war

The abrupt escalation of US-China trade war overshadowed Fed’s rate cut. Events last week caused a lot more turmoil than usual for financial markets. Global financial markets reacted quickly and negatively to mixed messaging by Federal Reserve Chair Jerome Powell.

The Fed cut rates on 31 July for the first time since December 2008, lowering the fed funds rate 25bps to 2.25% in a move widely telegraphed by Fed officials and wholly anticipated by financial markets. Attention was more focused on the Fed’s next move, and whether or not 25bps would be sufficient to “sustain the expansion.” Markets took the move as a mildly hawkish cut, with the yield curve flattening and equities falling in response. Chair Powell gave investors a lot to digest in his post-meeting press conference, particularly with his mixed messaging on whether or not this cut was the start of an easing cycle. Powell termed it a “mid-cycle adjustment” but also indicated the Fed was not necessarily done. We still expect the factors that necessitated this cut will compel the Fed to cut once more this year. Powell cited the “downside risks from weak global growth and trade policy uncertainty” and sub-target inflation as reasons to “insure” against an early end to the expansion. The FOMC also announced that its balance sheet run-off would conclude in August, two months earlier than planned.

The very next day, a tweet by US President Trump called for a 10% tariff on the remaining USD300bn in untariffed Chinese imported goods beginning September 1st. Adding to the uncertainty, Trump said that tariffs could go beyond 25% if trade negotiations remain stalled. Any goodwill from the Federal Reserve was quickly thrown into reverse. Global equity and commodity markets sold off with investors seeking the safety of government bonds. The tweet came after talks broke down during a brief meeting between trade representatives from the US and China.

Tackling these two events separately, financial markets wanted more clarity on the Fed’s commitment to further rate cuts. First off, many were puzzled as to why rates were cut at all given the solid performance of the US economy. The data last week confirmed that global developments had yet to take a significant toll on US economic activity. July payrolls came in as expected, with 164,000 jobs created, and wage growth firmed up slightly to 3.2% yoy. What’s more, consumer spending for June expanded at a healthy pace, and core inflation registered a slight improvement.

The reason why the Fed is cutting is simple. The data reflects past performance, and forward-looking surveys offer a slightly less favorable outlook. For example, July’s ISM manufacturing survey again edged down and is close to tipping into contraction. Moreover, growth in world GDP is strongly correlated with domestic business investment with a short lag. As a result, the half-point decline in global growth since last year has weighed on business investment enough to shave about a tenth of a point off US growth

Source: BIMB Securities Research - 5 Aug 2019