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Has the Fed succumbed to market pressure again and will other central banks do the same?

07 June 2019

In December last year the Federal Reserve (Fed) raised rates by 0.25% and indicated a further two rate hikes. Since then, things have taken a significant turn. This steadfast approach impacted negatively on markets and the fourth quarter of last year was difficult for investors, with some of the sharpest market falls in years. At the turn of the year, the Fed shifted towards a more "patient" stance and subsequently, in March, indicated no rate hikes in 2019. The Fed also pledged to end its programme to shrink its balance sheet by September this year. This dramatic U-turn led to a sharp decline in bond yields and boosted sentiment, as lower borrowing costs were expected to stimulate the economy. 

In recent weeks, global government bond yields have fallen sharply as investors have become more wary of geopolitical developments and their ramifications on the global economy. Expectations for a timely trade deal between the US and China were shattered, with both sides blaming each other for failing to reach a resolution. The US President, dubbed himself "tariff man" again, and vowed to escalate the scope of tariffs whilst continuing to target the embroiled Chinese tech firm, Huawei. China retaliated by threatening to cut off the supply of rare material imports to the US. With a resolution to the trade spat appearing further away than ever, Trump took the immigration "crisis" further by threatening tariffs on Mexico and has hinted at possibly withdrawing the exemption that remains in place for India. These developments have not been taken positively by equity markets.

Unpredictable trade policy has had enormous implications for global supply chains, which could effectively mark an end to globalisation, as we have seen its impact on global investments already. Survey data is already showing a pronounced impact and a decline in global growth is expected this year. Investors have now changed their expectations for Fed policy and the future market is pricing in two to three rate cuts by the end of the year. Earlier this week, Powell said the Fed will "act as appropriate to sustain the expansion", which suggests they are seriously considering rate cuts. This affirmation of market expectation for interest rates boosted equities but raises the question as to whether the Fed is responding to moves in risk assets, or to the real economy. Current surveys indicate that US growth will slow down from 3.1% annualised over the first quarter to 1.5%-2% for the remainder of the year. This is a significant reduction, but given that unemployment remains close to a multi-decade low and it could possibly stimulate retail spending, the Fed may have moved a bit early.    

While the Fed boosted market sentiment, the European Central Bank (ECB) was a source of disappointment. Members met earlier this week to update markets on the terms of its third long term loan operation. Given that some Eurozone countries have been flirting with recession, and the growing geopolitical risk, an increasingly dovish tone was expected. Their forward guidance shifted to indicate that interest rates will not be raised until the second half of next year, but the absence of a specific reference to potential rate cuts came as a surprise to some. There were numerous conditions attached to the new loans and most market participants expect that this will not lead to the meaningful increase in credit that is needed to boost growth. Issues surrounding the contentious Italian budget continue to linger, putting pressure on its sovereign funding costs, while ten-year German government bonds reached a new record low of -0.24%. Both of these indicate little expectations of future growth in the Eurozone and continued fragmentation.

The ongoing trade disputes are having an effect on economic activity, but the central banking community is not uniform in their reactions to the potential impacts. Only time will tell whether the ECB was right to hold fire or if the Fed was right to confirm market-based interest rate expectations, as predictions of trade resolutions have become increasingly difficult.  


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