July 01, 2019
Monetary Policy and Trade Uncertainty Drive Market Sentiment
Lawry Knopp, VP-Funding & Hedging
U.S. Treasury yields have continued to move lower as we reach the midpoint of 2019. Ongoing trade frictions, global economic weakness and elevated geopolitical risks are exerting downward pressure on U.S. Treasury and other sovereign debt yields. Markets are contending with the prospect of an economy that’s likely losing momentum as inflation slows while employment remains solid. Many members of the Federal Open Market Committee have indicated support for one to two 25 basis points rate cuts this year as the likelihood of sustained growth becomes less certain, especially for the manufacturing sector. The primary drivers of interest rates are monetary and trade policy.
The monetary policy statement by the FOMC following its two-day meeting in mid-June indicated the committee believes the most likely outcome for the economy is continued growth, strong employment and moderate inflation. However, the committee did acknowledge “uncertainties about this outlook have increased.” Furthermore, policymakers are closely watching developments in financial and international markets, as well as progress on a potential trade deal with China.
Nevertheless, the market is anticipating the Fed will ease policy rates multiple times over the next 12 months as federal funds futures indicate a 100% probability of a 25 basis points rate cut at the July 30-31 FOMC meeting. The chance of a second 25 basis points rate cut in September is around 80%. The likelihood of a third rate decrease of 25 basis points by December is about 60%. A significant change in the outlook, such as a major trade agreement or a shock to the financial markets, could delay or accelerate action by the Fed.
Now that the three-month Treasury bill yield has exceeded the 10-year Treasury yield for well over a month, focus on a yield curve inversion has subsided. However, history indicates when the yield curve inverts, the economy typically finds itself in a recession within six to 15 months. Inverted yield curves indicate the market believes monetary policy is too restrictive and central bankers are at risk of slowing economic growth to the point that economic activity begins to contract. If the Federal Reserve does ease policy rates by 75 basis points over the next six to 12 months, the yield curve will likely regain its upward slope. Whether the Fed can act quickly enough to avoid a recession is yet to be determined.
A look at the fundamentals of the economy (growth, employment and inflation) indicate consumer and business spending slowed in the first quarter, while net exports and inventories offset some of the slack. For the second quarter, consumer spending is expected to strengthen while business spending may weaken further with the potential for exports and inventories to become a drag on growth. Housing may provide a boost to the economy as mortgage rates have followed Treasury yields lower. Any potential gains from the housing sector will likely be temporary.
So far, the level of consumer sentiment remains strong. Expectations have been steady on a trend basis, while current conditions have deteriorated slightly. Concern over trade continues to influence consumer sentiment but has yet to have a material impact on buying habits, as was seen in recent retail sales figures. Looking at the inflation component of the recent consumer confidence report, expectations slipped further, declining to 2.2%, the lowest reading since the question was added to the survey 40 years ago.
Inflation remains moderate despite trade and tariffs headlines. This is largely due to the makeup of the consumer price index. The items that contribute the most to inflation are services and housing, which are mostly sourced domestically. For inputs that have been subject to tariffs, other sources and supply chains have been developed. The food category is a component of the inflation index where tariffs are likely having an impact, however; it makes up 13.2% of the overall index. The index, on a year-over-year basis for May, rose 1.8%, compared to 2.0% for April and 1.9% for March. For May, month-over-month food prices rose 0.3%, which was offset by a 0.6% decrease in energy prices. Energy amounts to 7.8% of the index.
Job gains have been choppy the last few months while the unemployment rate has held steady at a 50-year low of 3.6%. Job openings continue to exceed the official number of unemployed, which some suggest is due to a skills gap as businesses are having difficulty finding qualified workers. Weekly claims for jobless benefits remain low as the four-week average for new jobless claims is 221,000 and the 13-week average is 216,000. While the level of claims remains near historic lows, some are worried we are at or near the bottom. An upward trend in claims would likely signal a weaker employment outlook.
Regarding the U.S.-China trade dispute, in the past we’ve talked about the need for some level of pain associated with the trade tensions before meaningful progress on an agreement can be expected. The U.S. ag economy has experienced the brunt of the impact from higher tariffs while there has been modest slowing in consumer and business spending. Worries over higher inflation from the tariffs have yet to materialize, although pressure may be building.
Reduced exports to the U.S. have negatively impacted China’s economy and the Chinese government has responded with both monetary and fiscal policy stimulus efforts to cushion the impact of weaker exports and reduced economic growth. Presidents Trump and Xi recently met at the G-20 meeting in Osaka, Japan. The details of the meeting and what shape a potential trade deal will take has yet to be learned. Negotiations are expected to resume between the world’s two largest economies.
Elsewhere, the dollar is holding on to recent gains despite the expected shift in monetary policy. The dollar may decline should the Fed begin implementing rate cuts. Meanwhile, oil prices are relatively stable, notwithstanding efforts by OPEC and other major oil export-based nations to trim production and push prices higher. The trading range for WTI crude is $44 to $76 per barrel, with the current price indicated near $59 per barrel.
The Eurozone is also contending with economic weakness while it works through a messy Brexit and fragmentation among members of the European Union. The European Central Bank is also considering easing policy and implementing other measures to stimulate growth.
View on Interest Rates
The Federal Reserve is expected to ease policy rates by 25 basis points at either the July and/or September FOMC meetings. If the Fed eases policy rates by 25 basis points at both meetings, the next rate decrease would likely not occur until December or early 2020. It largely depends on whether a trade deal with China can be achieved. The Fed has indicated they are watching market developments closely and will respond “appropriately to sustain the expansion.” Look for longer-term Treasury yields to remain near current levels until the risk of recession begins to recede and inflation expectations rise.
A resolution to trade issues between the U.S. and China could significantly improve the global economic outlook and bring the perspectives of Federal Reserve policymakers and the market much closer together. The prospect of a lingering trade war without any progress on a trade deal will likely further weaken the global growth outlook and hasten more policy easing by the world’s central banks.
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