The Fuse

Softer Fed Stance Signals Growing Economic Concerns

by Nick Cunningham | June 05, 2019

On Tuesday, the U.S. Federal Reserve seemed to suggest that it was open to a cut in interest rates, undoing some of the increases from the past year. Equity markets welcomed the news, but the about-face is a sign that the central bank is worried about the deterioration of the global economy.

Looser monetary policy would, on its face, provide a jolt to commodity markets, boosting economic activity while also putting downward pressure on the U.S. dollar. However, the Fed’s softening line also highlights the growing fear of an economic slowdown.

A return to rate cuts?
Fed Chairman Jerome Powell seemed to warm up, ever so slightly, to a rate cut in comments on Tuesday. He addressed rising trade concerns and how it might affect the economic outlook. “We do not know how or when these issues will be resolved. We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion,” Powell said. The financial markets interpreted his comments as Fed-speak for a willingness to cut interest rates if the economy begins to sour.

“Powell may have opened the door a crack wider to the possibility that the Federal Reserve will ratify one or two of the rate cuts the markets have discounted this year,” Chris Rupkey, chief financial economist at MUFG Union Bank NA, told Bloomberg.

Powell also dwelt on low long-term inflation, which was the main reason for his comments at conference in Chicago. Stubbornly low inflation may also offer a justification for loosening monetary policy.

Stocks surged by more than 2 percent on Tuesday. Bond markets are pricing in the likelihood of rate cuts later this year. “The market is sending out invitations for a rate cut party, and waiting for the Fed to turn-up,” Greg Gibbs, director and founder of Amplifying Global FX Capital LLC, told Bloomberg. Powell “gave just enough hint that he might turn up, but he is still reluctant to acknowledge that risks to growth have increased.”

Lower interest rates would lower the odds of an economic recession, which would be welcome news for equities and commodities. A dovish turn from the central bank would also put downward pressure on the U.S. dollar. Because crude oil is priced in dollars globally, a weaker greenback tends to stoke demand. Crude oil was at its most expensive in the mid-2000s and again in early 2010s, not coincidentally two periods in which interest rates were at historically low levels.

But an interest rate cut this time around would be an extraordinary about-face, and an admission that the global economy is taking a turn for the worse. The Fed would be acting out of fear, forced to retreat from its rate-hiking campaign. While on the one hand a more accommodating monetary environment might be bullish for crude oil, the speed with which the central bank reversed course points to deeper concerns about the global economy.

Trade war and slower growth
Behind the negative outlook is expanding protectionism. The U.S.-China trade war has a cast a dark cloud over global GDP. The possibility that the U.S. and Mexico may begin a series of tit-for-tat tariffs only adds to economic woes. The two sides are still negotiating and could yet head off a trade war, but the prospect of more barriers comes at an inauspicious time.

In 2019, the world could see the weakest year for global trade since the financial crisis, according to ING. Trade may only expand by 0.2 percent this year, the weakest expansion since 2009. A growing number of major investment banks are sounding the alarm regarding an economic slowdown. Citibank says that GDP may only rise by 2 percent next year, again, the smallest increase in a decade. Morgan Stanley said that a recession would likely start within nine months if the Trump administration moves forward on raising tariffs on the remaining $300 billion of Chinese imports.

The U.S. economy has held up until now, but there are also some worrying signs of a slowdown. U.S. companies may have added the lowest number of new jobs in May in nearly a decade, according to ADP. Private sector employment may have only climbed by 27,000 last month, which comes after a downward revision of data in April.

JPMorgan Chase said that the odds of a recession in the second half of 2019 have climbed to 40 percent, up from its estimate of 25 percent a month ago. “Global growth now looks likely to slip below trend for the rest of this year,” JPMorgan wrote in a report.

The Federal Reserve will almost certainly wait until more data emerges before taking any action, particularly since the near-term outcome of multiple trade spats is unknown. So, for now, the bank probably will not be riding to the rescue.

That leaves oil markets seesawing higher and lower, dragged in both directions by global supply outages on the one hand, and a deteriorating economy on the other. For now, the bears are winning out. “Fears of an escalating trade war, particularly following the Thursday evening news regarding new U.S. tariffs on Mexico, have broken the camel’s back,” Bank of America Merrill Lynch said in a note. “[T]he decline in Global Manufacturing PMIs that started around the first round of US tariffs shows no signs of abating in the midst of the ongoing multiple open trade wars, another factor that could further depress oil markets in 2H19,”

On Wednesday, the EIA published more downbeat oil market figures. Crude inventories jumped by a surprise 6.8 million barrels in the last week of May, while gasoline inventories also rose by 3.2 million barrels. U.S. oil production also rose to a new record high of 12.4 million barrels per day. WTI plunged on the news, falling nearly 4 percent during midday trading.