• Market sentiment improved in September, with investors seemingly shrugging off the latest negative trade headlines
  • Italian fiscal woes present another potential source of market volatility in the near term
  • The Fed continues to move forward with gradual policy tightening, and there were no major surprises from the September FOMC meeting

The tone in global risk markets was improved in September, with both Treasury yields and major equity markets higher over the month. Investors were largely dismissive of the announcement of more tariffs against China, and communication from Fed leaders following the September 26 FOMC meeting points to ongoing “gradual” policy tightening for the foreseeable future. On the trade front, President Trump hailed the finalization of USMCA, the new agreement with Mexico and Canada which will replace NAFTA, and the three country leaders expect to sign the agreement before the end of November. There are no signs of easing tensions with China, but the markets appeared to shrug off the latest escalation. On September 17, President Trump announced new tariffs on $200 billion of Chinese imports. The tariff rate begins at 10%, and on January 1, 2019, the rate climbs to 25%. If China were to retaliate, the president threatened to initiate a third phase of tariffs, which would include approximately $267 billion of Chinese goods. As expected, China did indeed retaliate by announcing new tariffs on $60 billion of U.S. goods.

It is now likely that the United States will apply tariffs on all goods imported from China (~$500 billion) at some point in 2019, and these actions should put upward pressures on producer and consumer prices (inflationary) and weigh, at least modestly, on economic growth. China will likely continue to respond with additional fiscal and monetary stimulus to offset the impact of the tariffs, which should put more downward pressure on its currency relative to the dollar. J.P. Morgan equity analysts project that 25% tariffs on all Chinese imports would reduce 2019 U.S. earnings per share growth from 10% to 5%, which they predict would be the final nail in the coffin for the long-running U.S. stock market rally (positive for U.S. rates, all else equal).

Beyond trade tensions, it’s also worth keeping an eye on developments in fiscal and political challenges for Italy. The country recently released budget deficit projections that were well above expectations and create more tensions with eurozone leaders in agreeing to a budget plan within currency union rules. As Exhibit 1 illustrates, Italy has one of the largest bond markets in the world, and of those markets, only Japan has a higher debt/GDP ratio. As such, Italy presents much greater risks to the global markets than Greece did several years ago. Because of this, European officials are far more motivated to compromise on an ultimate solution, but in the meantime, this situation could spark pockets of volatility and demand for U.S. Treasuries.

Fed Staying the Course
The Fed offered no real surprises at its September 26 FOMC meeting. While a rate hike was all but assured, there was some speculation in the market that the forward guidance might shift a bit more hawkish. However, Fed leaders appear content to maintain consistency in its 2018 mantra of “gradual” and deliberate normalization in an effort to stay ahead of inflation and financial stability risks. Following another 25 basis points (bps) increase in the target fed funds range, the updated Summary of Economic Projections (SEP) revealed that the median participant forecast still shows one more hike in 2018 and three more in 2019 (unchanged from June). The official statement only had one notable change: as some had anticipated, the committee removed the word “accommodative” from its assessment of current monetary policy, suggesting that Fed leaders believe current policies are close to neutral. This change does not infer that rate hikes will end soon, and it is more likely that policy will eventually move into restrictive territory, a point reinforced by the Fed’s projected hikes in 2019 and 2020 that would go beyond the long-term neutral policy rate. At the same time, the aggregate projections for economic data and the fed funds rate present the optimal soft landing for the U.S. economy, which is just short of finding a unicorn from an economic and monetary policy perspective.

The markets continue to underprice the Fed’s projected rate hikes in 2019 and beyond, which is consistent with what happened in the mature phase of the last tightening cycle in 2004-2006. The median FOMC participant forecast for the fed funds rate at the end of 2019 is 3.125% versus fed funds futures pricing at 2.82%. If the Fed does indeed drive short-term rates beyond what current forward rates would imply, floating-rate assets should continue to perform well relative to short-duration fixed-rate assets. There are several headwinds that could keep an effective cap on long-end yields, including geopolitics, trade tensions, etc.

Lastly, the FOMC also chose to raise the interest on excess reserves (IOER) rate by 25 bps at the September meeting. The effective fed funds rate had drifted higher in recent weeks to only 2 bps below IOER, sparking questions of whether the committee might choose to again just raise IOER by 20 bps and push it closer to the middle of the target range. That did not happen, and it will be interesting to read the minutes of the meeting to assess just how concerned, if at all, policymakers are with this issue. They were clear in the June decision that they would ideally like the effective rate to be in the middle of the target range, but as a market-traded rate, there is only so much the Fed can do to control the effective rate…


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