Markets Hinge on Fed Decision

Markets Hinge on Fed Decision

Two weeks from now, the US Federal Reserve will meet.

As explained below, Jim is confident there will be no rate hike from the Fed.

But he does point out that there’s every chance a rate cut is coming. A rate cut would be partly in response to Trump’s tariffs, partly to avoid a stock market correction, and partly to avoid a US recession.

The actual result is going to come down to the wire, writes Jim.

But make no mistake: Either no change or a rate cut will ultimately be good for gold.

Read on for more.

Until next time,

Shae Russell Signature

Shae Russell,
Editor, The Daily Reckoning Australia

Trump Declares War

Jim Rickards, Strategist

Jim Rickards

Trump has had it!

He is apparently declaring a currency war on the rest of the world.

Trump resents China and Europe cheapening the yuan and the euro against the US dollar in order to help their exports and hurt America’s.

He says it’s time for the US to cheapen the US dollar also.

Trump has a point.

If you put a 25% tariff on many Chinese exports to the US (as Trump has done), or a 25% tariff on German cars exported to the US (as Trump has threatened to do), it can be a powerful way to reduce the US trade deficit and generate revenue for the US Treasury.

But a trading partner can undo the effect of the tariff just by cheapening its currency.

Let’s say a Chinese-made mobile phone costs $500 in the US. If you slap a 25% tariff on the imported phone, the immediate effect is to raise the price by $125.

A simple solution to tariffs is to devalue your currency by 20% against the US dollar. Local currency costs do not change, but the mobile phone now costs $400 when the local currency price is converted to US dollars.

A 25% tariff on $400 results in a total cost of $500 — exactly the same as before the tariffs were imposed.

Tariff costs have been converted into lower production costs through currency manipulation.

Betting on a rate cut

There’s only one problem with Trump’s currency war plan.

There’s nothing new about it. The currency wars started in 2010, as described in my 2011 book Currency Wars. 

As soon as one country devalues, its trading partners devalue in retaliation and nothing is gained. It’s been described as a ‘race to the bottom’. Currency wars produce no winners — just continual devaluation until they are followed by trade wars.

That’s exactly what has happened in the global economy over the past 10 years.

But the final step in the sequence is often shooting wars. That’s what happened leading up to the Second World War. Let’s hope the currency wars and trade wars don’t turn into shooting wars as they did in the 1930s.

Meanwhile, the Fed is a critical player in the currency war because it has a major influence on the US dollar.

The world is waiting to see what it does at its policy meeting on 31 July.

There is almost no chance the Fed will raise rates. The choices are to cut rates or keep rates unchanged. The market is betting heavily on a rate cut, for what it’s worth.

If the Fed cuts rates, we’ll have to see how other central banks react. But the Fed has many factors to consider when it meets later this month…

For the past 10 years, Fed policy changes have been relatively straightforward to forecast, based on a simple model.

The model said the Fed would raise rates consistently in 0.25% increments until rates are normalised around 4% (the amount needed to cut in case of recession).

The exceptions (where the Fed would ‘pause’ on rate hikes) would occur when job creation is low or negative, markets are disorderly, or strong disinflation threatens to turn to deflation.

Markets certainly became disordered late last year, when the US stock market nearly entered a bear market.

And so the Fed paused.

All eyes on the Fed

None of those conditions apply today. US job creation is strong, markets are at all-time highs and disinflation is mild. But a new factor has entered the model, which is the fear of causing a recession.

Estimated growth for the second quarter of 2019 is 1.3% annualised, compared with 3.1% in the first quarter.

Using the Fed’s own models (which are different from mine), the Fed is concerned that if it doesn’t cut rates, a market correction and recession may occur.

But if it does cut rates, inflation may result due to tight labour markets and higher costs due to tariffs.

This Fed decision will likely come down to the wire.

US second-quarter GDP will be reported on 26 July, and personal income and outlays will be reported on 30 July.

Both data points (and underlying inflation data) will be available right before the 31 July decision date.

Markets will cheer a rate cut and probably sell off if the Fed does not cut rates.

But both the markets and the Fed itself will have to wait until the last possible minute before this conundrum is resolved.

And the world will be watching very closely.

All the best,

Jim Rickards Signature

Jim Rickards,
Strategist, The Daily Reckoning Australia