Weekly: Litany of Risks
- 2019 Fed rate cuts are now fully priced in; we however wonder if that would help the markets
- FX: China has lately signalled a preference for currency stability; we think this is temporary
- Rates: Asia rates/govvies should benefit as lower-for-longer becomes the theme
- Equities: We are maintaining Thailand as neutral despite trade war-related headwinds
The list of downside risks to the global economy has lengthened considerably since the beginning of May. They include a sharp escalation in China-US trade wars, a considerable ratcheting up of US pressure on China’s technological capabilities and potential, rising tension around Iran, US spat with Mexico on immigration, and the US broadening trade tensions vis-à-vis India and Europe, along with currency manipulation charges against some key economies. European consumption and business sentiments have been weakening, whereas the rapid spread of Swine fever is wreaking havoc with meat production in China.
Due this litany of risks, general or idiosyncratic, our assessment of the global economic outlook has worsened considerably. A nascent recovery in trade and business sentiment has been undermined severely by an escalation and broadening of trade wars, progressively weak data prints, as well as a rise in geopolitical tension. The markets’ focus, in this context, is on the Fed. Should the US ease monetary policy, perhaps some of headwinds building up can be assuaged, and the long global expansion cycle can be prolonged, goes the thinking. In recent weeks, expectations of Fed policy easing have spiked sharply, as seen in the following chart.
Granted, despite the recent selloff, market volatility has risen only modestly. Monetary conditions are not particularly challenging, there have been no major events to suggest liquidity support is warranted, and policy makers in key economies are already sounding very dovish. Hence there is no immediate case for a rate cut, especially in the US, where the labour market is tight and wage growth strong, notwithstanding the dovish tone coming from senior Fed officials.
The fixed income market is pricing in a series of rate cuts nonetheless, predicated on the potential for lasting damage to the global economy from prevailing uncertainties, as well as the view that the real policy rate is too high at a time of ballooning downside risks and chronically below-target inflation.
From the US Federal Reserve’s perspective, it will become progressively difficult to ignore the market dynamics and pipeline economic risks, in our view. We are therefore now calling for 25bps rate cuts in September and December of this year.
The outlook for 2020 is exceptionally cloudy, as some sort of a resolution in China-US tensions could boost sentiments on one hand, whereas rising pass-through from higher tariffs could create a stagflation-type scenario on the other hand, constraining Fed policy. Considering this, we are leaving our call for no further changes in policy rates in 2020 unchanged.
Will the rate cuts accomplish much? We doubt it; the risks to economic slowdown is not coming from high cost of capital. Moreover, there is no link between tariffs and monetary policy. Furthermore, given the considerable rise in public and corporate debt burden over the past decade in the US, a tad lower interest rate payment won’t act as a catalyst to pile on more leverage, in our view.
The Fed’s motivation to cut rates would stem from the need to be seen doing something, and the notion that lowering real rates would help soothe the credit channel at a time if heightened risk aversion. That the policy rate cut could come in less than three months from now also implies that Fed policy would not be pursued in response to data releases, which may well remain broadly fine for the US in the near term. A hint or two on growing inventories, further unrest in global financial markets, and a worsening of inflation expectations would be sufficient, in our view.
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