June economic update: Monetary policy to the rescue

Recent US data suggests the economy is becoming less resilient to the negative trade headlines and the Federal Reserve is signalling moving in the direction of policy easing. This is fuelling market expectations of aggressive stimulus – in line with President Trump’s demands for 100 basis point of rate cuts. We think precautionary 50bp rate cuts from the Fed are likely.

Neither China nor the US seem willing to back down right now and it looks as though trade tensions will escalate further. But in the end, we believe President Trump wants to get re-elected and a deal will be done. After all, lower interest rates can only do so much to support the equity market (and Trump’s perceived re-election chances) if the core problem – trade – isn’t dealt with and global growth deteriorates further.

In China, we think the authorities will increase fiscal stimulus, as well as cut interest rates and the reserve requirement ratio (RRR) to support growth, in what is a difficult environment for Chinese companies in the trade and technology sectors.

Some of the green shoots we observed last month in the eurozone might be nipped in the bud if the trade war continues to escalate. The initial figures for the second quarter are mixed, though it’s too soon to pencil in a stalling of the recovery. While the European elections were basically a non-event, the political risk in Italy is rising again. Slowing growth and declining inflation expectations have forced the European Central Bank to introduce an easing bias in its communication. The path forward now looks open for a rate cut in the coming months.

Boris Johnson is odds-on to become the next UK prime minister, prompting concern that he could push for a ‘no-deal’ Brexit. But a new leader will face the same hurdles as Theresa May, and parliament would likely trigger an election if a ‘no-deal’ is imminent. In the meantime, the uncertainty will continue to keep a lid on economic growth.

Japan’s 1Q19 GDP was an impressive 2.2%, but the details behind that growth are far less impressive, and growth in 2Q and beyond could struggle. With the Fed looking more dovish, the Bank of Japan will be looking anxiously at the USD/JPY rate, and wishing it had some effective tools left in its monetary arsenal. Unfortunately, it has none.

The drop in US interest rates has undermined the dollar. If this is the start of the long-awaited dollar decline, we expect it will be USD/JPY that leads the charge. Macro-political challenges in Europe mean that EUR/USD will struggle to better the 1.15 level.

On market rates, one of the nuances that we identify is the likelihood that the Fed under-delivers on the market rate cut expectations. This could force long rates lower as the disappointment on the extent of the delivery of cuts prompts investors to switch out of risk assets into Treasuries, which still offer a positive yielding risk free rate.