Volume 23, Issue 24 June 10, 2019.

  Source: Globe & Mail

Fed’s Rate-Cut Finger Getting Itchy as Global Trade Risks Rise
Michael Gregory, CFA
BMO Deputy Chief Economist

 

In his opening remarks to the Fed’s confab on Monetary Policy Strategy, Tools and Communication Practices this week in Chicago, and before touching on the theoretical and longer-term topics the conference was considering, Chairman Powell revealed, definitely, that global trade risks were now on the FOMC’s policy radar.  The Fed’s head said: “We do not know how or when these issues [recent developments involving trade negotiations and other matters] will be resolved. We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion…”

Last month’s escalation of the U.S./China trade war was a tipping point as far as the U.S. economic outlook was concerned. For us, it shifted our growth forecast from a slightly above-potential track to a slightly below-potential profile, cementing our call for Fed policy being on hold indefinitely. The negative shock from tit-for-tat tariff hikes and hoisted non-tariff barriers was going to have a direct economic impact, lessening U.S. exports and imports. The annual change in both nominal goods exports and imports was already negative in April. But, it was also going to have an indirect impact, depressing business confidence. Relatively low hiring in May could be a sign of the latter, after core capital goods orders dropped in April.

However, the escalation was also a game-changer as far as the risks surrounding the outlook were concerned. It significantly lifted the odds of additional tit-for-tat actions with China and a broadening of America’s trade war to cover non-North American automotive imports, which would elicit retaliation from the likes of the EU and Japan. It also appears to have emboldened the Administration to employ tariffs as a tool for something other than trade policy, in the case of looming duties on Mexico (owing to which Mexico will surely retaliate).
 
At some point, the combination of trade-war dampened economic performance and trade-risk dimmed growth prospects will compel the Fed to ease policy. The on-the-ground evidence is not yet compelling (see Sal Guatieri’s Thought on page 3).  Indeed, a slightly below-potential pace at this very late stage of the business cycle— with the economy boasting the largest positive output gap since 2000 and the lowest jobless rate in 50 years—could even be considered welcomed. Perhaps the trade war is now doing what FOMC-projected rate hikes were supposed to do back in December.

Unless the economy deteriorates rapidly, a Fed move is more likely to be elicited by the intensification of risks to the outlook. Markers on this journey could come as early as when “emergency powers” tariffs actually get put on Mexican goods or the June 28-29 G20 meeting should Presidents Trump and Xi not play nice in the sandbox (possibly followed by a Trump tweet proclaiming Section 301 tariffs on all remaining Chinese goods).

Tariffs (like other taxes) are inherently growth-sapping; but, they are also, potentially, inflation-boosting. However, the secular forces of disinflation driven by technology-enabled disruption and demographics appear not only to be effectively checking the cyclical inflation pressures prodded by full employment, but also ensuring that tariff hikes, so far, haven’t fuelled the inflation process. Core PCE inflation was 1.6% y/y in April, with the shorter-term trends suggesting little upward pressure ahead. The subdued readings also reflect the impact of turn-of-the-year weakness in the economy if the Dallas Fed’s trimmed-mean PCE inflation metric is any guide.

On balance, between sub-target core inflation prints persisting despite tariffs and full employment and the risks of significantly slower economic growth owing to the global trade war, the chances of “risk-mitigating” Fed rate cuts are increasing sharply. The Fed has temporarily eased policy on past occasions to address acute shocks facing the U.S. economy (1987 and 1998 were examples). They could do so again.

The Bank of Canada is already on alert, stating that “global trade risks have increased” in its May 29 policy announcement. However, unless Fed easing coincides with the U.S. economy deteriorating rapidly, we doubt the Bank is going to immediately match the Fed’s initial risk-mitigating rate cuts. The BoC’s core inflation measures are much closer to the 2% target (they averaged 1.9% y/y in April) and the policy rate, at 1.75%, is currently negative in real terms (the Fed’s is positive). Also, having brought a semblance of stability to the housing market (Vancouver aside… see Robert Kavcic’s Feature on page 7) with a tandem of multijurisdictional macro-prudential policy and central bank rate hikes, we suspect the Bank will be careful about risking some of this stability with rate cuts. We also suspect how the Canadian dollar fares amid initially-unmatched Fed rate hikes will likely be a key determinant of the timing of any subsequent Bank of Canada action.

Finally, this week, the Reserve Bank of Australia cut its policy rate in the face of slowing domestic economic growth, persistent sub-target inflation and, for the global economy, the fact that “downside risks stemming from the trade disputes have increased.” Could this be a Fed omen?


Have a great week.

Frank & Mark




Source: Globe & Mail, BMO Capital Markets, Bank of Canada

Canada:
 

With global equity markets rallying last week, the TSX added a much more muted 1.2%, with the energy sector a drag on the index. WTI oil prices slumped into bear market territory at one point, before finishing the week firmer at around $53. The Canadian data run was positive, with a strong showing on trade supporting our call for a Q2 real GDP growth rebound, while the employment report was solid despite some uninspiring details.  Year-to-date, the TSX is up 13.3% and the benchmark 10-year yield was slightly lower ending the week to yield 1.46%.


U.S.:
With the growing expectations that the Fed is poised to cut interest rates, the S&P 500 jumped 4.4%, led by materials, technology and industrials, though the index remains below the April high.  Friday’s payrolls report only got the rate-cut chatter ringing louder. Nonfarm payrolls rose a modest 75,000 in May, and the downside surprise came with downward revisions in each of the prior two months. Wage growth also decelerated despite the jobless rate holding at a near half-century low. Let’s just say this is probably not comforting for the Fed, which has an eye on the ongoing trade war, and is likely more sensitive to downside risks than upside risks, given already historically-low rates and still next to no inflation pressure. Indeed, that was the subject of much of Fed Chair Powell’s speech last week.  Year-to-date, the S&P 500 is up 14.6%, the Dow Jones Industrials are up 11.3%, and the Nasdaq is up 16.7%. The yield on the 10 year Treasury closed at 2.09%. 


Source: BMO Capital Markets 

The Good: Employment +27,700 (May); Jobless Rate -0.3 ppts to 5.4% (May)—45-yr low; Average Hourly Wages +2.8% y/y (May); Merchandise Trade Deficit narrowed to $1.0 bln (Apr.); Labour Productivity +0.3% (Q1); Ivey PMI steady at 55.9 (May).


The Bad: Auto Sales -5.9% y/y (May); Capacity Utilization -0.9 ppts to 80.9% (Q1)—lowest since 2017Q1; Markit Manufacturing PMI -0.6 pts to 49.1 (May).