Three and done
’Three and done’ was the story of 2019. A hot economy and rate normalisation in 2018 gave way to fears of a global recession, triggered by the Chinese slowdown and an escalating trade crisis; initial expectations of four more hikes yielded to a mid-cycle adjustment of three consecutive 25-basis point cuts in July, September and October.
Strong US economic data and some positive developments in trade negotiations (relatively speaking) in November all but ensured that the Fed would hold rates this month. On the trade front, a consensus has formed that the US and China will not implement tariff hikes scheduled for 15 December, which would impact another $160bn of consumer sensitive Chinese imports. We support this view, as the political risks to President Trump from re-escalating trade tensions heading into the 2020 election are high.
Perhaps even more significant but overlooked due to the announcement of Presidential impeachment clauses on Tuesday was the signing of USMCA, the successor trade deal to NAFTA. The combined size of US trade with Canada and Mexico is roughly $1.13trn, almost double the $640bn of US-China, so the resolution of the North America trade question is possibly a bigger win for the US economy, albeit less headline grabbing.
If the abatement of these geopolitical risks is sustained, the early green shoots in US and global manufacturing could take root. Conversely, return of trade policy uncertainty would drag down business sentiment and investment again, potentially forcing the Fed back into easing mode. The Fed has acknowledged the fluidity of the situation with their frequent pledges to “monitor the incoming data.”
US economy is "in a good place"
Fed members’ predictions of future interest rates, last updated in September, shifted down to include the October cut and now indicate a 25-basis point hike in 2021 and a 25-basis point hike in 2022. Expectations of GDP were left unchanged at 2 per cent for 2020. Projected long-term unemployment ticked down slightly to 4.1 per cent while both headline and core PCE inflation are expected to be 1.9 per cent in 2020.
Like a patient completing a successful round of therapy, the US economy is now “in a good place”, as asserted by Jerome Powell in the 11 December press conference. The data bears out that claim: rate cuts have re-stimulated the housing market, consumer confidence remains resilient, the US is experiencing the strongest labour market for 50 years, and there are early signs of a stabilisation in manufacturing.
Expansion set to continue despite risks
The bar for either lowering or hiking rates from here is high. Hawkish voting members have an abundance of strong data to argue their case, while dovish members will point to core CPI still well within the Fed’s “symmetric target” of 2 per cent. But as noted above, the balance could be easily disrupted by a tweet, a diplomatic reversal or another unforeseen event.
That said, we must give credit where credit is due - the Fed appears to have successfully engineered a soft landing, by remaining flexible and taking a U-turn when events called for it.
The US expansion looks set to continue for a little longer, though likely at a slowing rate. This bodes well for risk assets and poorly for Treasuries. Nevertheless, stark downside risks persist and would most likely emanate from politics. So while the US economy can enjoy being “in a good place” at the end of 2019, complacency is the one risk the Fed cannot afford to take.