The Federal Reserve lowered its Federal Funds Target rate twenty-five basis points on Wednesday to its current target range of 2.0% to 2.25%. The members do not believe we are late-cycle, but in the middle of an economic pause that warrants accommodation. Thus they “preemptively” lowered interest rates to ward off economic risks. Additionally, the Fed indicated that it is likely to lower rates at least one more time this year depending on the data. While the U.S. economic readings have slowed and confidence indicators have slipped, the data itself is not particularly weak. However, the Federal Reserve is looking at global data and we think rightfully worried that weak global economies will start to hurt our own, if they haven’t already. The global economy is more interconnected than ever, and it is unlikely the U.S. can permanently withstand the effects of weak global growth.
Global trade has been falling, partially due to tariff issues and currency manipulation. After decades of globalization there is pushback not only in the United States but abroad against “free trade.” The media frequently portrays this as a President Trump issue, but NPP thinks this is a distortion of the facts on the ground. While trade with China is one of President Trump’s core issues, he is not the only one who shares a distrust of their policies. Many Congressional Democrats as well as Republicans agree and are angry with China’s trade practices. In a world of slowing global growth, countries are trying to stabilize and prop up domestic economies. Japan and South Korea have been feuding over trade and Japan just dropped South Korea from its “white list” which will result in restrictions on high tech imports to Japan from South Korea. Global Central Banks in Europe and Japan have extremely loose monetary policies with the unstated aim of weakening their currencies against the dollar. This has the net effect of placing a “tariff” on imports into their countries from the United States. “Free trade” is becoming a victim of countries around the world turning inward to protect their domestic economies.
The drop in the Federal Funds Rate may help weaken the dollar or at least prevent it from strengthening as the U.S. attempts to ride out this trade war. A rapid appreciation of the dollar will almost certainly hurt manufacturing which is the opposite of what President Trump and Congress want. Make no mistake, there are almost never winners in trade wars. As a net importer, the U.S. is likely to be a relative winner while we lose absolutely. Global trade tensions add to overall market risks and the Federal Reserve must remain cognizant of them and react accordingly.
Falling interest rates and a hoped-for pick-up in inflation would likely counteract these issues. Interest rates have crashed globally. All German government bonds yielded less than zero as of August 5th meaning that any bond purchased in German’s largest economy would earn investors a negative return if held to maturity. In the U.S., the slope of the Treasury curve is currently inverted. Long-term inversions usually precede recessions, although short-term inversions have less predictive value. The Federal Reserve has not mentioned it, but one concern of theirs must be the shape of the yield curve. We believe one of the best arguments for further rate cuts is the goal of steepening the yield curve. While we have sympathy for the argument that the long-end of the yield curve is being affected by negative foreign interest rates, we still think that the yield curve signals problems ahead and should not be ignored.
Many critics of the Federal Reserve’s move to lower rates pointed to the strong US domestic data as evidence that it was unnecessary. We feel that one or two additional cuts are warranted given low domestic inflation numbers and the yield curve inversion. Core inflation is running around 1.6%. We are not sure why the Fed is targeting 2% inflation, nor are we sure that 2% annual inflation is better than 1.6% inflation. Nevertheless, risks are growing, and we don’t think one or two more data-dependent rate cuts will stoke inflation.
As the new week begins, equity markets around the world are giving back some of their recent gains. Over the weekend, China let their currency fall below the psychologically important level of seven Yuan to the dollar. This was clearly done in retaliation to Trump’s proposed increase in Chinese Tariffs beginning September 1st. In addition, the move has sent interest rates around the world even lower. The US 10-Year Treasury Note yield has fallen to 1.75%, further increasing the yield inversion with 3-Month US Treasury Bills and putting pressure on the Fed to cut rates at the next meeting. The US equity markets are up sharply year-to-date and were due for a correction. The news certainly gives investors a reason to take some profits here. Still, we believe the resilient U.S. economy and additional Fed rate cuts will keep growth positive. This should help to minimize the depth of the current correction.