The dollar is undergoing a correction as the slide in US interest rates accelerates in response to the renewed tariff threats. Once again, we think US rates markets are getting too pessimistic on the US outlook and so we are sticking with our broad macro calls that were working well until the tariff news hit last Thursday.RECENT DEVELOPMENTS
President Trump has ratcheted up trade tensions. He said 10% tariffs will be slapped on the remaining $300 bln of Chinese imports that have not yet been affected, effective September 1. Trump added that the tariffs could easily go “well beyond” 10% if needed. China has retaliated by suspending purchases of US agricultural goods.
The onshore yuan traded above 7 today for the first time since early 2008. For offshore CNH, it was the first time it has ever traded with a 7-handle. Of course, this will bring on complaints from President Trump, but we believe the weak yuan is largely reflecting broad-based EM FX weakness. The correlation between CNY and MSCI EM FX is currently around .82, which means the yuan is very much subject to greater market forces. We do not think the yuan will be “weaponized.”
US rates markets reacted quickly to the renewed tariff threats. The implied yield on the January 2020 Fed Funds futures contract has fallen to 1.46% from 1.80% last week. Three more cuts this year are now close to fully priced in, with WIRP suggesting 100% odds of a cut at the next meeting September 18. Looking further out, the implied yield on the January 2021 Fed Funds futures contract is currently around 1.03%. This suggests that two more cuts next year are nearly priced in.
Powell admitted at last week’s FOMC meeting that the Fed is still trying to figure out how to react to global trade tensions. As such, we cannot say what the Fed’s likely reaction function is right now. Markets clearly believe the Fed will bail Trump out again, but we are not so sure. The Fed should not reward bad trade and fiscal policies with rate cuts.
We’ve said it before and we’ll say it again: it simply makes no sense to risk a global trade war and recession to get the Fed to cut rates. Easier monetary policy is a second-best response to a trade war. What’s the first best? End the trade war by eliminating the tariffs.
We can understand why the Fed will be reluctant to cut again so soon. Part of it is bad optics. President Trump has been jawboning the Fed for lower rates. While risks to the US economy have risen, we do not think the Fed wants to be seen as caving to Trump’s demands. The Fed is also correct to note that the impact of the tariffs has yet to be fully felt and so remains unknown.
Our broad macro calls will be tested over the next two weeks with another big data dump for the US. July PPI will be reported Friday, CPI next Tuesday, and retail sales next Thursday. Of these, retail sales will be the most important. The firm labor market has helped sustain consumption this year. If US firms try to pass on the higher tariff costs on to consumers, then retail sales are likely to suffer.
We believe the Chicago Fed National Activity Index remains the best indicator to gauge US recession risks. The 3-month average was -0.26 in June, the best since February and well above the recessionary threshold of -0.7. The July reading will be reported August 26. Note that a value of zero shows an economy growing at trend. Positive values represent above trend growth, while negative values represent below trend growth.
Overall, the US economy remains in solid shape. The Atlanta Fed’s GDPNow model is tracking 1.9% SAAR growth in Q3, down from 2.2% previously. This is still close to trend (~2%) and little changed from the preliminary 2.1% SAAR in Q2. Elsewhere, the NY Fed’s Nowcast model is tracking 1.6% SAAR growth in Q3, down from 2.2% the previous week.
Last week ended on a solid note for the data. The US economy added 164k jobs in July vs. 165k expected, while the June gain was revised down from 224k to 193k. The 3-, 6-, and 12-month moving averages are currently at 140k, 141k, and187k. Average hourly earnings picked up to 3.2% y/y and was higher than expected. JOLTS data continue to show a tight labor market, with the June reading out Tuesday expected to show continued tightness.
Yet the 3-month to 10-year curve has inverted further to -27 bp, overtaking the July 4 cycle low near -25 bp and signaling even greater recession risk. We acknowledge that the impact of ongoing trade tensions is unpredictable and just the sort of exogenous shock that can tip an economy into recession. Using the shape of the US yield curve, the New York Fed calculates the probability of a US recession 12 months ahead. This fell to 31.5% in July from the cycle high of 33% in June. We expect this to rise again in August.
We remain dollar bulls but just like the Fed, we are struggling with how to compensate for the trade war. Powell admitted last week that the Fed is still trying to figure out how to react to global trade tensions. Markets clearly believe the Fed will bail Trump out again. We are not so sure. The Fed simply should not reward bad trade and fiscal policies with rate cuts. With growing risk-off sentiment, the dollar should eventually benefit from renewed safe haven flows.
For now, we are sticking with our broad macro calls. These include no US recession, a stronger dollar, higher equities, and a bearish steepening of bond yields. These calls were coming to fruition last week, but the renewed tariff threat led to a huge reset across all markets. Our calls hinge critically on our view that the trade wars will not trigger a US recession this year. All of these calls will be tested time and again this year and we expect heightened volatility across all markets in the coming months.
The data remain key. If the outlook changes and the economy slows significantly or even goes into recession, then the Fed will have no choice but to adjust its expected rate path significantly lower. For now, we think the rates markets are getting too negative once again. Until they adjust again, the dollar may have trouble getting traction near-term. Yet at some point, markets will be left wondering whether the euro looks that much better than the dollar.
EM will likely remain under severe pressure. The less dovish than expected Fed, renewed trade tensions, and broad-based risk off sentiment have conspired to absolutely crush EM FX and equities. These drivers are carrying over into this week and so we remain bearish on EM. MSCI EM has broken below the May low near 982 and is on track to test the January low near 945.50 and then the October low near 930. Likewise, MSCI EM FX has broken below the May low near 1609 and a break of the 1607 area would set up a test the September low near 1575.