Twists & Turns -

Twists & Turns

Sep 20, 2024Jeremy ParkinsonFinance, No picture0

Image Source: UnsplashMARKETSAfter Thursday’s euphoria, where Wall Street soaked up the glow of the Fed’s rate cut, Friday brought a reality check as the rally sputtered. The post-cut high has given way to a more grounded realization: at some point, growth will have to do the heavy lifting for stock valuations moving forward. We’re now in this strange part of the cycle where let’s face it, everything feels weird. Some on Wall Street are questioning if the Fed is behind the curve in steering the economy toward a “soft landing,” while others think there might be too many cuts already baked in. And, of course, whispers of a tech bubble are never too far from the conversation.Personally, I’m taking the middle road—flat for the first time in what feels like forever. It’s time for a clean slate. As the dust settles, the focus will shift to the parade of Fed officials hitting the circuit, who may provide a little more insight into the thinking behind this week’s hefty rate cut.Fed Governor Waller was quick off the mark, hinting at the Fed’s readiness to move aggressively if needed. “If labour market data worsens, or inflation continues to come in softer than expected, we could accelerate the pace of cuts,“ he said before throwing in the curveball that a fresh uptick in inflation could also lead the Fed to hit the brakes on further easing.In short, the message is clear: if jobs data nosedives, the Fed could go big again, which would likely send a shiver through the markets, and the ripple effect might not be so pretty.But in reality check fashion, hawkish Fed Bowman said the big cut could be seen as claiming victory too soon.And so the debate rages on—50 or 25? Markets are on the fence, with odds split roughly 50/50 on whether we’ll see another 50 bp rate cut in November. As it stands, traders are pricing 75 bps of easing by year-end, spread across the remaining two meetings.As for the Fed possibly going too far, inflation expectations have crept up, but they’re still circling the 2% target. And let’s be real—that will be the next big question on everyone’s mind, especially if Trump starts pulling ahead convincingly in the scientific polls. If that happens, brace yourself because markets will watch the Fed and the political landscape like hawks.Oil prices have crept up, too, partly due to renewed tensions in the Middle East, though year-on-year losses in oil prices have now exceeded 20% for two straight weeks.We’re also nearing quarter-end; let’s not forget that the November election is about to ramp up. No wonder things look murky on the horizon. Polls show the two primary candidates neck and neck, although betting markets give Democrat Kamala Harris a slight edge.Despite the choppy waters, the equity market seems convinced the Fed has already secured a soft landing—at least based on index levels. The S&P 500 is trading at a lofty 21x forward earnings, assuming a healthy 10% earnings growth for 2024 and an ambitious 15% growth in 2025.But here’s the rub: beneath the surface, growth jitters will persist unless job data takes a convincing turn. No matter what the Fed says, the market could be in for a rude awakening if the macro picture falters. With no major economic releases on Friday, traders are already looking ahead to next week’s reports: preliminary U.S. business activity data, the final revision on Q2 growth, and the latest on consumer spending—all potential market movers.On the global stage, Japan and China’s central banks held steady on rates Friday. Given the alarming slowdown in its economy, China’s decision came as a bit of a shock. The People’s Bank of China unexpectedly left lending rates unchanged despite almost 70% of market participants expecting a cut. Some had speculated that the PBoC would not follow the Fed’s lead to avoid looking tethered to U.S. policy.Whether this is a delay ahead of broader stimulus remains to be seen, but the pause has undoubtedly helped the national currency —the offshore yuan hit a fresh 16-month high.Meanwhile, in Japan, the Bank of Japan left its policy unchanged, too, holding back on further tightening even as it upgraded its economic assessment. Core inflation ticked up to 2.8% in August, right on target, but with the yen’s strength and weaker stocks keeping inflation in check, the BOJ may not be in such a hurry to normalize rates. Unsurprisingly, the yen slipped back above 144. Frankly, the BoJ was walking a tightrope yesterday, and their objective was not to weaken the yen, but neither did they want to erode the domestic wealth effect by sending the local market adrift with a hawkish overtone. We’re still bullish on the yen as a policy divergence play, but let’s not beat a dead horse here—we need to see some weakness in the US data to keep that momentum going. Without that, the yen’s potential remains in waiting mode.It’s a market full of twists and turns, and next week’s Fed chatter could bring even more surprises. Stay tuned because this ride is far from over!NUTS & BOLTSThis week, the Fed’s bold half-percentage point cut in the federal funds rate sent shockwaves through Wall Street, leaving many economists scratching their heads. The message from the Federal Reserve couldn’t have been more explicit: the focus has shifted to the employment mandate, with growth and jobs taking center stage over inflation concerns. The goal? To safeguard economic expansion and prevent the unemployment rate from shooting past the Fed’s estimated NAIRU (Non-Accelerating Inflation Rate of Unemployment), currently sits at around 4.2%.It’s no secret that the decision was contentious, with the dot plot revealing a near-even split between those in favour of a 50 bp cut and those leaning towards 25 bp. Michelle Bowman’s dissent—the first of its kind since 2005—added to the drama as she publicly preferred the smaller move. The Minutes from this meeting, set to be released in three weeks, will be a must-read. They might just be more gripping than your latest Netflix binge! Investors will pour over every word to understand the Committee’s divisions and gain insights into the economic and inflation outlooks and the Fed’s next steps.The timing of the Fed’s aggressive cut is particularly notable given that inflation pressures, especially in services and housing, are still lingering. Yet, he brushed it off when Powell was pressed on housing inflation during his post-FOMC presser.On the other hand, the downside risks to U.S. economic growth have been fading fast, even before the Fed’s rate cut. Economic data has consistently outperformed expectations. Initial jobless claims dropped another 12,000 this week to 219k—the lowest level since May—defying forecasts. Meanwhile, the Conference Board’s Leading Economic Indicators improved to -0.2%, no longer signalling a recession. In case you missed it, U.S. equity markets hit record highs, long-term and short-term interest rates have nosedived, and financial conditions have drastically loosened since August’s market scare.With financial markets riding high and a new, lower rate path firmly in place, economists are raising their near-term forecasts for U.S. consumer spending and GDP growth. The Fed’s decisive action and robust retail sales data have likely boosted Q3 and Q4 consumer spending estimates. Hence, the more robust growth outlook may keep the economic engine humming even as labour markets cool.But here’s the nagging question: is there enough slack in the economy for inflation to drift down to the Fed’s 2.0% target comfortably, or will this surge in economic activity bring inflation back into focus as the Fed’s next big headache? Only time will tell, but for now, the Fed has given the economy a lifeline—let’s hope it doesn’t come with strings attached later.US ELECTION AND CHINAThe upcoming U.S. presidential election holds significant implications for Beijing, especially if the former president makes a comeback and follows through with his promise to jack up U.S. tariffs on Chinese imports by a staggering 60% to 100%. Such a move would deliver a painful blow to China’s fragile economy, though it’s unlikely to push the country into a full-blown recession in 2025. The real risk lies in escalating pressure on an already wobbling economy.Predicting the impact of a tariff hike is no easy task. Beyond hammering China’s exports, much will depend on how Chinese and multinational companies respond—whether they double down on moving production outside of China, for instance. Beijing’s reaction is also a significant wildcard, particularly if it opts for retaliatory measures or ramps up fiscal stimulus.From a more mechanical standpoint, estimating the direct effect of the tariffs appears somewhat easier.Using BMO’s calculations :

The show that a 60% tariff could shave 1.1 percentage points off China’s real GDP growth in 2025, driven by the direct hit to trade. The real question is how much more damage could come from reduced fixed investment. If China’s exports shrink and drag down GDP, it would create excess capacity—leading to slower growth and lower fixed investment over time. Assuming a gradual adjustment over three years, that could slice off another 2 percentage points from GDP in the first year.

But before jumping to conclusions, it’s essential to consider some mitigating factors. One potential buffer is China’s ability to reroute goods through intermediary countries like Vietnam or Mexico, as recent U.S. Fed research suggests this has already helped offset some of China’s lost market share since the trade war began. And, of course, Beijing is unlikely to sit quietly if hit with a 60% tariff. Targeted retaliatory measures would almost certainly be on the table, though they probably wouldn’t match the scale of the U.S. tariffs.China might also loosen the fiscal reins slightly, offering modest stimulus to counter the economic hit. Another option could be letting the renminbi depreciate, but Beijing would be wary of triggering capital outflows with such a move. Altogether, these measures could soften the blow by boosting growth by about 0.5 percentage points.BMO’s Key Takeaway

If the U.S. imposes a 60% tariff, our baseline forecast for China’s 2025 real GDP growth could fall from 4.5% to 2.0%. While our estimate is on the higher end of other projections, there’s a large margin of error—primarily because Beijing’s response remains a major unknown in this economic chess game.

CHART OF THE WEEKChen Zhao of Alpine Macro, a fantastic Montreal-based macro shop says: I am stunned by those who claim that the Fed is already too late to ease and a recession is unavoidable even after the Fed dropped rates by 50 bps and stocks have been booming. Too late for what?

The ( Alpine Macro ) chart shows that policy becomes too tight only when the real Fed Fund rate exceeds real GDP growth, and a recession usually follows. We are not there yet, and the Fed is easing.