Fed hikes rates again. Could a trade war derail future rises?
As expected, the Fed raised interest rates yesterday following its September policy meeting. Could the escalating trade war between the U.S. and China impact plans for future increases?
Mission accomplished - now it's time for the normalisation of interest rates
The U.S. Federal Reserve (the Fed) raised interest rates again yesterday, marking its eighth hike for the expansion. Fiscal stimulus has pushed U.S. GDP (gross domestic product) growth rates well above the economy’s long-term potential, the unemployment rate is hovering near a 50-year low1 and core inflation is within a rounding error of the Fed’s 2% target.2 For a central banker, that’s basically mission accomplished. Now, it’s time for the Fed to get the funds rate back up to normal levels — and we see yesterday’s decision as part of a careful and gradual sequence of hikes designed to achieve that normalisation.
Economists widely anticipated yesterday’s move by the Fed. One important nuance of the Fed’s statement yesterday was that the central bank decided to remove a key sentence that previously said “the stance of monetary policy remains accommodative, thereby supporting strong labour market conditions…” Put differently, with the federal funds rate now breaching 2%, the Federal Open Market Committee (FOMC) no longer sees interest rates as being particularly supportive to the economic outlook. We are entering the more mature phase of the tightening cycle which, in a very simple sense, diminishes how many cumulative hikes the Fed will likely be able to deliver going forward. Bond markets initially staged a small rally on the news with the 10-year U.S. Treasury yield dipping very briefly to 3.06%.
While yesterday’s decision came as a surprise to no one, the Fed’s response to events over the next several months could prove to be pivotal for financial markets.
Trade wars and the near-term Fed path for interest rates
Market participants have used a range of adjectives to describe the recent escalation of trade tensions between the U.S. and China — from spat to skirmish to war. It feels like a trade war to us. With the new penalties that went into effect on Monday, the U.S. has now imposed tariffs on roughly half of all imports from China. And the guidance from President Trump is that “if China takes retaliatory action against our farmers or other industries [which they did on Monday], we will immediately pursue…tariffs on approximately $267 billion of additional imports”. That escalation, which looks increasingly likely, would mark a full-blown trade war with effectively all bilateral trade between the U.S. and China being exposed to new and significant penalties.
Ultimately, what the Fed needs to assess here is the risk of any knock-on effects from these tariffs onto consumer and business confidence, hiring and capital expenditure (capex) plans. Thus far, the U.S. economy has demonstrated resilience to this risk factor. Manufacturing confidence, as measured by regional Fed surveys, still looks optimistic through preliminary readings for the month of September. We suspect that the earnings boost from tax cuts has partially offset the angst from trade policy. But that doesn’t mean we are out of the woods yet. The duration and magnitude of the trade escalation both matter. Anecdotally, some businesses have said they will cut back on capex if trade uncertainty lingers. Directionally, we are also seeing some evidence of a margin squeeze on the manufacturing sector, with tariff-related increases in input prices that have outstripped companies’ abilities to pass these costs onto U.S. consumers.
That being said, in our minds, the domestic economic picture in the U.S. is simply too strong right now for the Fed to slow down in front of trade concerns that may or may not act as a hindrance to growth. Historically, the U.S., as a relatively closed economy, has been more resilient than other regions to external shocks. We are seeing that again yesterday, and a more-of-the-same baseline view is probably still the right one for the next three months. But the uncertainty around this view is larger than normal. As such, we expect that the Fed will raise rates again at its December meeting, but our subjective probability on that call is only 60%.
How (high) can you go? Gauging the appetite for a restrictive U.S. policy stance
Abstracting from near-term concerns around trade policy, we generally see the U.S. economy continuing on a path of above-trend growth that will challenge the Fed to transition its policy setting from accommodative to neutral to restrictive over the next 12 months. Our outlook would be consistent with an inversion of the U.S. Treasury yield curve in 2019. And, when we get to that point, we expect a much more vigorous debate to commence on the FOMC about the need for additional hikes in the face of what has historically been a reliable precursor for U.S. recessions.
Indeed, regional Fed presidents Bostic, Bullard and Kaplan have said they will not support raising rates beyond the point of a yield-curve inversion. Nevertheless, our read of the comments from past and current Fed leadership (Bernanke, Yellen, Powell, Williams) and the Fed staff suggests they are likely to keep hiking beyond this point (both because they are downplaying the signal from the yield curve yesterday and because the risks of an overheating are likely to continue increasing as the cycle matures). Taken together, we look for an additional three to four rate hikes in 2019 and see a terminal fed funds rate of 3.25 to 3.5% for this cycle, with recession risks building into 2020.
The intersection of macro and markets
Our outlook for U.S. monetary policy is generally in-line with market pricing over the remainder of 2018. But the cyclical pressure on bonds could step up in 2019 in the form of gradually accelerating inflationary pressures and a slightly faster Fed than what is currently discounted. Tactically, these cyclical arguments for higher 10-year yields are offset by a record speculative net-short position in Treasuries. Our research suggests yields are likely to fall over the next one, three and six months at these extreme short levels, as market positioning has become very vulnerable to bad news (whether it comes from the U.S.-China trade policy or another catalyst). All told, we expect the 10-year Treasury yield to still be trading near 3%, 12 months from now. As such, our preferred positioning on U.S. government bonds remains close to neutral.