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  • FOMC expected to start laying the groundwork for a rate cut 
  • Lighthizer's appearance before the Senate Finance Committee will be watched for any spark of optimism about US/Chinese trade relations
  • U.S. housing starts expected to remain solid
 

FOMC expected to start laying the groundwork for a rate cut -- The market is discounting only a minor 18% chance of a rate cut at the 2-day FOMC meeting that begins today.  The FOMC is under heavy pressure from President Trump for a rate cut, but the FOMC in our view has not yet laid enough groundwork for a rate cut.

Fed officials in recent comments have nodded towards the possibility of a rate cut if the U.S. economy weakens.  However, the Fed in our view will not want to cut rates as soon as this week for fear of being accused of buckling under pressure from the White House.  In addition, the FOMC may want to keep its ammunition dry in the event that the US/Chinese trade war turns much worse if President Trump goes ahead with his threat to impose a 25% tariff on another $300 billion on Chinese goods after the June 28-29 G-20 meeting.

Fed Chair Powell has so far hinted at a rate cut only as a contingency in the event that the U.S. and global economy start running into significant problems.  There was been some troubling U.S. economic data recently such as the May payroll report of only +75,000 and the -0.7 point decline in the ISM manufacturing index to a 2-1/2 year low of 52.1 in May.  

However, the U.S. stock market remains strong and there has been some offsetting solid economic data such as last week's +0.5% increase in the May retail sales report, which suggested that consumer spending remains alive.  U.S. consumer sentiment also remains at historically strong levels.  The Atlanta Fed's GDPNow forecast for Q2 GDP is currently at +2.1%, which is slightly above the Fed's estimate of a long-term U.S. potential GDP growth rate of +1.9%.

Yet the Fed is also concerned about the inflation outlook.  Both the headline (+1.5% y/y) and core (+1.6% y/y) PCE deflators in April were decisively below the Fed's inflation target.  In addition, the core PCE deflator in April showed an even weaker increase of only +1.3% on a 3-month annualized basis.

More worrisome than the current inflation statistics is the fact that inflation expectations have dropped very sharply in the past two weeks, suggesting that the market believes Fed policy is too tight and that inflation is headed lower in coming months.  The 10-year breakeven inflation expectations rate has plunged by -15 bp in the past eight sessions and fell to a new 2-3/4 year low of 1.61% on Monday.

While a rate cut this week seems unlikely, the FOMC is likely to start laying the groundwork for a rate cut at the next meeting on July 30-31 (with market odds at 82%), if only to placate the markets and not appear as though it is ignoring threats.  The FOMC this week is likely to downgrade the Fed dots in a more dovish direction from the current view of an unchanged funds rate this year and a +25 bp hike in 2020. The FOMC is also likely to adopt more dovish language in its post-meeting statement.  The FOMC this week will have plenty of opportunity to indicate a more dovish policy bias shift since Fed Chair Powell will be holding his usual press conference and since the FOMC will release an updated set of economic forecasts and Fed-dots.

 

 

Lighthizer's appearance before the Senate Finance Committee will be watched for any spark of optimism about US/Chinese trade relations -- U.S. Trade Representative Lighthizer will be on the hot seat today in an appearance before the Senate Finance Committee defending the Trump administration's aggressive use of tariffs to pursue trade and other goals.  Many in Congress from both parties were opposed to President Trump's recent threat to impose tariffs on Mexico in pursuit of migration goals.

In any case, the markets will be listening carefully to see whether Mr. Lighthizer thinks there are good odds for a restart of US/Chinese trade talks if Presidents Trump and Xi do in fact meet at the G-20 meeting starting next Friday.  The markets seem to be relatively optimistic about a restart of the trade talks and a deferral of Mr. Trump's threat to impose a 25% tariff on another $300 billion of Chinese goods.

However, the markets may be overly optimistic about the chances that Mr. Trump's new tariff will be averted, which means that the U.S. stock market could be vulnerable to a steep drop if there is a negative outcome from the G-20 meeting.  If Mr. Trump goes ahead with those tariffs, then China is likely to respond harshly with even higher tariffs on virtually all U.S. products, a cut-off of rare earth metal exports to the U.S., and possibly a crackdown on U.S. companies operating within China.

The markets are also afraid of what Mr. Trump's next threat might be if he goes ahead with a 25% tariff on nearly all of U.S. imports from China.  At that point, Mr. Trump could raise the tariffs even higher, put more key Chinese companies on the U.S. trade blacklist, start placing restrictions or sanctions on Chinese state-owned companies, crack down on dollar-denominated capital availability for China, or a host of other ideas.  The pressure is high on Mr. Trump to move soon to his maximum trade actions against China since time is running out on his first term and China may soon just switch to a strategy of letting the clock run down.

U.S. housing starts expected to remain solid -- The consensus is for today's May housing starts report to show a small increase of +0.4% to 1.240 million, adding to April's solid gain of +5.7% to 1.235 million.  Housing starts remain in strong shape near the 2-year moving average.  Housing starts continue to be supported by the sharp -112 bp plunge in the 30-year mortgage rate seen from last November to the current 1-3/4 year low of 3.82%.  However, the markets will watch to see if home builders are getting cold feet from the recent doubts about the U.S. economic outlook after the NAHB index on Tuesday fell by -2 points to 64.

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