|05 August, 2019

Fed's attempt at policy divergence undone by fresh trade tariffs

Monte Safieddine is a market analyst at IG Dubai. He has spent nearly a decade in the FX industry and has held roles within financial firms that have included risk, analysis, statistics, and trading. Safieddine holds a Masters in Economics from Wayne State University where he completed multiple PhD-level fields and taught undergraduate students. He provides commentary on financial markets, including FX, cryptocurrencies and commodities, and publishes IG’s Daily Market Report and Weekly Market Report.

Website: https://www.ig.com/ae

Impact of US tariffs on the remaining $300 billion worth of Chinese imports will force the Fed into further easing and US companies into a tight corner

Last Wednesday’s Federal Reserve rate cut by 0.25 percent was fully priced in by money markets and the first by the United States’ central bank since 2008, but Fed Chair Powell’s less than expected dovish talk shortly thereafter during his press conference made it clear that the rate cut wasn’t the first of many nor part of an easing cycle, reinforced by two dissenting votes on that evening’s rate cut. 

That shifted rate cut probabilities, as prior to the July 31st meeting, Fed Fund Futures had been fully pricing in a second rate cut and majority pricing in a third one by the end of this year. 

The results took markets by surprise as the US dollar gained lost ground and equities that had risen anticipating Fed easing retraced off recent record highs. By the time the dust settled, a third rate cut was no longer expected, and a second rate cut not fully priced in for the year. 

While trade risks and global growth worries were cited as concerns by the Fed Chair, the divergence between a relatively stronger US economy and the remaining main regions like China and Europe where data had been disappointed was still intact. 

That would ideally result in a divergence in monetary policies, where the Fed would attempt to rebuild its arsenal in order to have the necessary tools to react in the event of an economic downturn, instead of just relying on increasing its already massive $4 trillion balance sheet courtesy of the last Great Recession.

Instead, Thursday’s shocker whereby US President Donald Trump announced that a 10% tariff on the remaining $300 bn worth of Chinese imports would go into effect on September 1st has all but removed that ability, forcing the Fed instead to likely react as soon as its next meeting in reducing rates further.

Equities further retraced off the highs, commodities dropping despite a weakened greenback, and yields plummeted around the world with Germany’s 10-year at near -0.5 percent and its 30-year briefly touching negative territory as investors fled into safe haven products.

Rate cut likelihoods have also surged back up, with Fed Fund Futures now fully pricing in a 0.25 percent rate cut come September, and the majority pricing in another rate cut in October. 

This is all assuming the trade war doesn’t spiral out of control, for as it stands companies like Apple that have products manufactured in China will be forced into three main options: (1) absorb those costs to avoid losing market share but dent company earnings, (2) pass them onto consumers which will seep into inflation rates down the line but suffer a drop in demand due to higher prices, or (3) pay up a one-time cost to shift elsewhere in the hopes that other manufacturing hubs have both the infrastructure and skilled labor to produce at similar costs to (at least partially) offset the 10 percent tariff.

Factoring in a situation where retaliation provokes further retaliation, and more companies will start to shift out of China depending on their breaking point and the circumstances involving the goods that are currently produced in China, with those involving lower skilled labor and laxer on infrastructure requirements at greater risk of shifting sooner rather than later.

At this stage, in terms of economic growth, the upside momentum is limiting at best, with downside risks very heavy as geopolitical tensions fail to subside, trade risks spiral out of control, corporate costs (and debt) expected to rise, and the net result future earnings taking a hit.  Risks the Fed has been forced to react to, even at the risk of dwindling its monetary options further.

* Any opinions expressed in this article are the author’s own

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