Sniffing Out a Cut in Interest Rates - June 10, 2019

The broad-based S&P 500 Index posted its first weekly advance in five weeks. While some of the gain can be traced to short-term oversold conditions, the trigger came from expectations the Fed may be gearing up to cut interest rates.

Oddly enough, the catalyst was President Trump’s decision to place tariffs on Mexico beginning with a 5% levy scheduled to go into effect on June 10 (tariffs could still be delayed or called off).

A 5% hike probably wouldn’t do much economic damage, but the potential to rise to 25% by October is another matter.

Enter Fed Chairman Powell, who, in a prepared speech on Tuesday, remarked the Fed “will act as appropriate to sustain the expansion.” That’s FedSpeak for a rate cut. Similar comments came from other Fed officials last week.

The cliff

Medium and longer-term bond yields have fallen off a cliff amid concerns that rising trade tensions will slow U.S. economic growth and further pressure global growth.

Let’s look past the politics (if that’s possible) and focus on the economics. The graphic below illustrates that U.S. exports accounted for 12.2% of U.S. GDP last year. China accounted for 0.9% of the U.S. economy, and Mexico, which is the 2nd largest U.S. trading partner behind Canada, made up for 1.4%.

If trade with Mexico and China were to cease, we’d fall into a recession. It’s not simply the 2.3 percentage-point hit to GDP, jobs indirectly tied to trade might also be in jeopardy. Plus, a weak economy would encourage additional layoffs in unrelated sectors.

Good news – trade won’t cease. Problem – it’s difficult to model how proposed trade barriers may eventually impact the overall economy. We don’t have a modern historical precedent.

The reality – tariffs encourage retaliation, gum up delicate supply chains, and dampen business confidence. That could slow business spending and hiring. We see the possibility playing out in recent stock market volatility and falling bond yields. While the economy is unlikely to stall tomorrow, new barriers to trade raise the odds of such an event 6-12 months from now.

The cavalry to the rescue

Odds of at least a 0.25 percentage point cut in the fed funds rate at the July 31 Fed meeting rose from 30% on May 30 to 87% as of June 7 (CME Group). And the Fed is isn’t pushing back.

It might be difficult for any Fed rate cuts to completely offset negativity of a full implementation of Mexican tariffs, but a shift in the Fed’s language last week encouraged a bout of buying.