While Donald Trump has been demanding the Federal Reserve cut interest rates, the US central bank has insisted it will continue to act independently of politics. Wall Street now expects the president will get his wish by another means: by harming the US economy so much that it will force the Fed to move.
As the US trade wars have escalated, from the breakdown of talks with China in early May to Mr Trump’s threat to impose tariffs on Mexico at the end of the month — traders have shredded their previous expectations for rates.
The plan to impose escalating tariffs on Mexican goods unless the country agrees to help curb migration from Central America to the US caught investors by surprise and led several prominent forecasters to reappraise their outlook for monetary policy last Friday.
The reaction in markets was swift and significant. The two-year Treasury yield, (one measure of the US government bond market most sensitive to interest rates) tumbled 14 basis points to 1.92 percent last Friday, its third-biggest one-day decline of the past decade.
That move capped a 34bp drop over the course of May, the largest monthly decline for the two-year yield since November 2008 at the depths of the financial crisis. Policymakers at the central bank have said they still think economic growth is resilient enough to not have to trim rates, but Fed vice-chair Richard Clarida last Thursday vowed to be “nimble” and opened the possibility of an easier policy if the economic outlook deteriorates further.
Fed futures funds show that the most likely outcome is that the Fed will cut once or twice by the end of 2019, with the first move potentially coming in July. Some investors are placing bets on even more drastic action. The probability of four cuts before the end of 2019, which had been zero since the start of the year, now stands at almost 6 percent.
In other words, it is almost as likely as the Fed’s current official projection it will keep rates on pause; the market-implied probability that rates will be unchanged at the end of December is down to just 8 percent from about 74 percent at the start of the year.